You’ve heard of Ponzi schemes or pyramid schemes I take it. If not, let’s familiarize ourselves with that they are and how to recognize one if you see it. First of all Ponzi schemes are named after Charles Ponzi, an Italian con man in the US and Canada in the 1920s. His schemes promised investors a 50% % return in 45 days or 100% in 90 days. He would achieve such results by buying postal reply coupons at a discount abroad and redeeming them at face value in the US. This was he said a form of arbitrage. In reality though he just paid earlier investors with investments from later investors. Someone has to win for the scheme to be believable so they tell their friends to invest or reinvest the proceeds greedily. This is a type of marketing cost that the swindler counts on. Given most marks are the greedy type the money often comes full circle back into the conman’s pocket. Over the course of the scheme he cost investors over $20 million in 1920s dollars. In today’s dollars that is around $384 million at 3% inflation over 100 years. Not a bad haul after all.
Since then there have been many notable Ponzi schemes. One recent one that stands out is that of Bernie Madoff in 2008. The amount he swindled was close to $65 billion in total although post recovery what’s missing is closer to $18 billion. To put that into perspective the post recovery missing amount is bigger than the GDP of many developing nations such as Jamaica and Albania. That’s some fine living!
Madoff started out as a legitimate player in the financial markets so he had the bonus of credibility He was the former executive chairman of NASDAQ and a Wall Street market maker. As a result people did not question him too much even though his returns were too good and too steady. They figured he must have some sort of investing “secret sauce” to get those results. In reality his bookkeepers made up fake trades and brokerage statements that gave the results he wanted to show. The funds he took in were used to fund his lavish lifestyle and to pay off earlier investors as in a typical pyramid scheme. People begged him to take their money and reinvest those proceeds. His elite circle of contacts enabled him to defraud the rich, primarily Jewish acquaintances in NYC and Florida, via something called affinity fraud. He also duped celebrities. See below if you recognize any.
The Madoff HBO move Wizard of Lies is great. Please watch it and learn how such a scheme operates.
Another classic Ponzi scheme example was oil and gas company Enron…the Crooked E. This one was actually a public company with an opaque derivatives based business model no one really understood. Many employees lost their jobs and life savings that the had plowed into company stock when the scheme collapsed. They also had a nasty stain on their resumes. Try to get hired with Enron or Madoff on your CV or resume.
So what should we watch out for?
Ponzi schemes usually have several defining characteristics.
- The fund returns promised seem too good compared to normal market returns in the stock market. The market is composed of many savvy investors and beating them on a regular basis is very hard. This is what they mean when they say the market is efficient.
- The returns from the fund are too steady. Say 25% per year every year. Investment returns are normally volatile. Some years are good and others not so. You might even lose money on certain years due to recession or some other macroeconomic factor.
- There is a “secret sauce” to how the money is made but they won’t reveal how it’s done or are purposely vague about it.
- These are not offered by a legitimate trading house or bank such as say Fidelity Investments, Goldman Sachs, Merrill Lynch, JP Morgan Chase, Credit Suisse
- Professional money managers stay clear of them
- Brokerage statements are not professionally audited by a legitimate accounting firm or seem too good to be true. Too lucky. Too made up. This is not always the case as Enron had legit, big name auditors (Arthur Andersen).
- Early investors are used as testimonials to get later investors to sign up. See Aunt Sally in Florida made 150% return and you can too! This gives the fund credibility. Yes, the early investors do get paid a nice return but often they reinvest and lose it all out of greed. In reality the funds pool is used to pay them off but it is critical to get the money reinvested so there may be strong pressure to do so. The winner may also be an inside man just like in the shell game or three card monte one used to see in NYC duping tourists. A real fund manager will never use testimonials as they can’t achieve steady returns and worry about lawsuits from claims like that.
- The fund in general has an opaque nature. Real funds need to publish their holdings in statements. Ex it has 2 million shares of Google and 1 million shares of Apple.
- The fund manager or managers live a lavish lifestyle. They have nice offices, cars, houses and membership at all the country clubs and social clubs. These managers need to project an aura of success to lure new clients, err suckers. Marks assume that the lavish houses and offices mean this guy knows what he is doing!
- The manager of the fund is some sort of savant and only he can get those results because he is special.
- Finally there is an aura of pressure to sign up. You don’t want to miss out right? Better sign up now buddy! Invest your cash now before the window closes!
But there are investments that have made fantastic returns over time! True! Think of the lucky schmoes who invested early in say Microsoft, Google, Apple or Facebook. Sure they have done very well but each has has had rough years and good years too. Apple almost went bankrupt before Steve Jobs came back and introduced the Ipod and Iphone. And you know what you are buying. …shares in a public tech company with audited financials. Microsoft for example sells software and rents server space. It’s not rocket science to understand. Google sells advertising you see on this very site and many others. For every one of these stars the road is littered with multiple failures like Pets.com, Theranos and AOL. How is a fund manager to know what’s good and not by foresight? They can’t so they bet on a pot of them and hope some do well.
If you suspect you or your loved ones have been swindled by a Ponzi scheme you can do the following
- Go see a CPA and have them look over the financial statements. You may also need an attorney.
- Try to withdraw some money if you can with the promise to reinvest. You just have some bills to pay. If they won’t let you withdraw that’s a red flag. If you can withdraw all your money great. Don’t reinvest it no matter what the pressure. You might be one of the lucky ones. Some funds may have holding periods but those are often clearly spelled out from the start.
- You may need to call the authorities as in SEC, CFTC, state agencies. If you are the whistle blower you are entitled to certain legal protections.
Again be wary and smart. If it sounds too good to be true it probably is! There is no special sauce to stellar returns. If there was some way someone one would have found it by now and returns would normalize over time.
Mr. Cash Hoarder 