This article originally appeared in Forbes.com.
Years ago, traffic authorities posted signs with the words, Stop, Look, and Listen, at railroad crossings and intersections to keep motorists and pedestrians safe. Investors might heed the same advice before falling for an investment that “just can’t fail”.
Ponzi schemes are in the news. A recent Wall Street Journal article (subscription required) highlighted the risks of investment fraud, including Ponzi schemes, and identified specific frauds in Colorado and Washington. A Google search on August 8th turned up two “top stories” about recent Ponzi schemes, in Boston and Florida.
The most famous and largest Ponzi scheme of modern times was, of course, Bernie Madoff’s, which was prominent enough to spawn a major motion picture with A-List stars. Madoff defrauded thousands of investors out of billions of dollars.
Why are Ponzi schemes so popular, both with fraudsters and with investors, and how can you avoid becoming a victim?
A Ponzi scheme (named for Charles Ponzi, who carried out a large fraud in the 1920s) pays the “investments” of late-arriving participants as “returns” to early participants. That is, A puts money in, and the fraudster takes it. Then B puts money in, and the fraudster pays some of it out to A and steals the rest. C puts money in, which goes to B and A, etc. The con artist needs only a good story about the “investment” and a lot of confidence in delivering it. Investors find it hard to resist the story of a high return investment available only to a select few. The scheme survives and prospers until A or B ask for their principal back. Of course, there is no principal — that’s the nature of a Ponzi scheme. No money was ever invested and the fraud collapses. The fraudster goes to jail, and the victims lick their wounds and mourn their losses, rarely seeing their money again.
Often, Ponzi schemes are popular, either with the public, or with groups of friends. Popularity provides an aura of credibility — if everyone you know is investing, the investment must be OK, and it seems foolish to be left out. FOMO (fear of missing out) strikes again!
Victims’ stories are heart-rending. Retirees lose their entire life savings and are forced to return to work. Families lose college funds, threatening their children’s futures. The loss shatters dreams and destroys lifelong plans. Victims are also in shock — how could they have been deceived?
How can you avoid being a Ponzi scheme victim?
- Keep your money under your control. Stop! Don’t write a check directly to an advisor. Purchase every investment in an account you own at your independent custodian (such as Schwab, Fidelity, or TD Ameritrade) or your securities broker (e.g., Morgan Stanley, LPL, Merrill Lynch, etc.).
- If your custodian or broker won’t hold the investment in question, that is a big red flag. It means either your custodian/broker has done due diligence on the investment and not been satisfied, or the offering is too small to justify a diligence investigation. In either case, stay away.
- If your advisor doesn’t work with a reputable custodian or broker, this is also a red flag. Custodians and brokers provide valuable services to advisors and their clients. There is no reason to choose an advisor who doesn’t offer you the support of a reputable custodian or broker.
- Keep your money where you can see it. Look! It’s difficult for an advisor to use your investment to pay earlier investors if it stays in your account at your custodian or broker, and you have 24/7 access to it. (Madoff victims did not have direct access to their accounts, and relied on statements that Madoff, not their brokers, issued). Reputable custodians and brokers provide online access to your accounts, and issue statements monthly, or at least quarterly. If you want your money, you should be able to go online and sell any investment, or call and do the same, with the proceeds coming to you by check or going directly to your checking account.
- Don’t rely on your friends or the public at large to make your investment decisions for you. You are investing your money, it should be your independent decision.
- Ask questions and insist on reviewing information about the investment from an objective third party. Any reputable investment advisor should be happy to show you a prospectus (a document filed with the SEC) for any investment they are recommending. Your motto should be: “no prospectus, no investment, no way.”
- Invest only in what you understand. An important element of an exciting investment story is mystery. It’s deliberately complicated, so other investors can’t figure it out. Or, the opportunity is limited, so only a select few investors can access it. No. If you can’t explain the investment to a ten-year-old, you don’t understand it well enough to invest your hard-earned money.
- Diversify. If you limit your investment in any one security to a small fraction of your wealth, failure of that security can’t hurt you. If you can’t resist the scheme, at least you can resist risking a large fraction of your wealth.
- Review your investments regularly. Listen! Follow up on any irregularity. Your advisor should be able to explain every transaction in your account and every decline. If you are not satisfied with the explanation, take your investment elsewhere.
But these ideas are just common sense, you say. I agree. And therefore, unfortunately, they can’t be enough by themselves. Most investors are endowed with common sense, yet Ponzi schemes recur and investors keep falling for them.
The reasons must have to do with social pressures — fitting in, keeping up, managing our appearances to ourselves and others — or with hopes and dreams that seem out of reach.
Jason Zweig wrote insightfully about Madoff’s scam, observing that investors responded to:
- Its murkiness: Current investors must have been people who knew and understood more than most.
- Invitations to invest from friends: Knowledgeable current investors were respected and trusted so subsequent investors relied on their judgment rather than their own.
- Its exclusiveness: Invitations to participate were hard to come by. Once the invitation arrived, flattered recipients didn’t want to ask hard questions or appear ungrateful for fear of missing out (FOMO again).
Unfortunately, countering the attributes of the scam ultimately required common sense (we seem to be back to where we started). The attributes contain an important hint, however.
Ultimately, Ponzi scheme victims are fooled, hoodwinked. They accept a false narrative as true. To avoid being a victim, you may need to find someone who won’t be fooled to help you determine the narrative is false. If you find yourself in a situation where Zweig’s factors apply, stop and consider whether you’re making an important decision in an information vacuum. Ask yourself what you really know about the investment. If the answer is “not much”, find out more before committing funds. Then, get an objective opinion from an outsider — someone who is not in your friend group, and ideally, is unacquainted with the people whose judgment you are relying on for the investment you are considering. You may not be able to save yourself by yourself, but you may avoid devastating loss by finding someone else to help you think it through.
When you see an investment that looks to good to be true, stop, look, and listen. It probably is.