What to watch out for to avoid investment scams

31 October 2023
Spotting scams

Unraveling Ponzi’s schemes: avoiding financial fraud

In this post, we delve into the art of detecting dubious financial deals. We explore the valuable lessons drawn from some of history’s most infamous scams, such as those perpetrated by Charles Ponzi and Bernie Madoff, to equip you with the knowledge needed to protect your assets and investments.

Who was Charles Ponzi?

Back to 1920s New York, Charles Ponzi conceived what seemed like a brilliant business idea. He noticed that international reply coupons, included in letters sent abroad, could be redeemed for stamps in the recipient’s country. Cunning Ponzi discovered that in certain places, the coupon’s cost was lower than the price of US stamps, allowing him to buy coupons in Italy, exchange them for stamps, and profit from the price difference.

Ponzi believed he had struck gold. But to make his plan work, he required a significant amount of capital that banks were unwilling to lend. Undeterred, he turned to individual investors, promising to double their money in a mere 90 days.

Surprisingly, this promise attracted a flood of capital to Ponzi’s operation. In six months, he amassed $2.5 million in investments – equivalent to about $30 million in today’s currency.

However, a problem emerged. To fulfill his obligations, Ponzi needed to transport tens of thousands of coupons from Europe, which was costly. His greed led him to a fraudulent method of delivering returns: he started paying early investors with money from later ones, creating an unsustainable chain with no actual profits.

The scheme grew rapidly, with 40,000 individuals entrusting their savings to Ponzi, lured by promises of massive returns. Eventually, investigative journalists exposed the scheme’s inadequacies, revealing that it would have required 160 million coupons in circulation for it to be legitimate – in reality, only 27,000 existed.

The downfall was imminent. Investors panicked and demanded their money back. With Ponzi deeply in debt, the entire operation collapsed. An estimated $250 million in today’s money was lost, and investors who had invested their life savings saw their finances crumble. Ponzi himself ended up in jail and ultimately penniless.

But did we learn from history? Not quite. Charles Ponzi might have been history’s most renowned scam artist, but he certainly wasn’t the last. The allure of enormous profits continues to be a potent weapon for unscrupulous individuals preying on investors.

Bernie Madoff and pyramid schemes

Ponzi’s name has become synonymous with fraudulent schemes in which investors’ money is used to pay off others. These schemes are intrinsically unsustainable, as no actual profits are generated – funds are merely shuffled around until it all collapses.

Bernie Madoff‘s fraudulent operation was the most extensive, unveiled in 2008. Madoff, once a respected investor, claimed to employ a sophisticated investment strategy promising consistent returns of 10-20% annually. In reality, he deposited investors’ funds into a bank account and used later investors’ money to pay off earlier ones. When the 2007-2008 financial crisis hit, the scheme crumbled as investors clamored for their money.

The crucial difference between Ponzi and Madoff was scale: Madoff attracted around $65 billion, more than Bulgaria’s GDP. Even global banks like HSBC and Santander lost over $1 billion in the process, showing how even sophisticated investors can fall victim to such scams.

Pyramid schemes vs. Ponzi schemes

While similar, pyramid schemes have subtle distinctions. Both rely on a continuous influx of new investors, but pyramid schemes require participants to recruit the next batch of victims, rewarding them with commissions for bringing in new investors. Pyramid schemes are also often illegal.

In addition, multi-level marketing companies, like Herbalife and Amway, have a similar structure. These companies encourage salespeople to recruit more salespeople further down the chain in exchange for a portion of their revenue. The key difference lies in these companies’ focus on selling actual products, rather than simply funneling money up the chain. Nevertheless, the distinction can sometimes be subtle, and certain governments, including China, have banned them altogether.

Protecting yourself

To shield yourself from fraudulent schemes, be very cautious when promised exorbitant returns and asked to recruit other investors. Always insist on examining financial accounts and gain a thorough understanding of how returns are generated. A secretive company should raise a red flag, especially when they claim secrecy is necessary to protect their competitive advantage.

Checking if a company is regulated is another layer of protection, though Madoff’s case showed that even seemingly legitimate firms can be deceptive. Scams tend to proliferate during market bubbles, so stay vigilant during these times.

Crypto scams

Cryptocurrency has witnessed its share of Ponzi schemes in recent years. BitConnect was a Bitcoin lending platform where you’d deposit money that was then lent to other people, and in exchange, you’d receive a “guaranteed” return of 1% per day. For example, if you put in $1,000, you would have $1.4 million in two years. Plus if you deposited more cash, you’d receive greater returns, and there was a multi-level marketing element that offered commission to people signing up investors to the platform.. Authorities eventually intervened, shutting down the platform and leaving token holders with significant losses.

Another brazen crypto scam was the Pincoin ICO, which offered an astonishing 48% monthly return. This lure led to the collection of $660 million before the founders vanished, leaving investors empty-handed.

The cryptocurrency market, with its intricate technology, potential for substantial returns, and lack of regulation, offers a fertile ground for scammers. During such times, exercise extreme caution and conduct thorough research.

“Regulated” doesn’t always mean safe

Regulation doesn’t guarantee safety. Financial regulations can be complex, and even when followed to the letter, they can still leave investors vulnerable. Some firms market risky bond products as “fixed rate accounts,” misleading investors about the safety of their capital.

Even bank accounts can be risky under certain circumstances. Before the 2008 financial crisis, many British savers placed their money in Icelandic bank accounts for higher interest rates. When those banks collapsed, their savings disappeared.

Even when the law is followed to the letter, loopholes and legal trickery mean that things aren’t always as they seem. Some peer-to-peer lenders (platforms that let you offer loans to small businesses and individuals) and so-called innovative finance companies tend to bury information about risks on their websites. They market their returns as almost guaranteed when in reality you’re taking on a lot of risk.

To safeguard your funds, consider government-backed bank accounts, like FSCS-protected accounts in the UK or FDIC-insured accounts in the US. While these accounts may offer lower returns, they come with government-backed guarantees.

Remember that financial rewards correspond to equivalent risks. High returns indicate higher risk, so conduct research and due diligence.

How to spot a scam

Trusting your instincts is a good start, but it might not be enough. With a little research you can hone your scam-detection skills. Here are some key factors to consider:

  1. Reputation: Rely on reputable financial sources and comparison sites for recommendations. Trusted outlets like Money Saving Expert (UK) and NerdWallet (US) are invaluable resources.
  2. Leadership: Investigate the individuals behind the company. Are they experienced financial professionals or amateurs? Search for the company directors’ names to check their involvement in past scams or controversies.
  3. Regulation: Verify the company’s claims of regulation with relevant authorities. Don’t take their word for it; conduct your own research to ensure they are regulated for the specific services they offer.
  4. Return generation: Scrutinize how returns are actually generated. Be wary of companies that are vague about their investment strategies.

While there is no foolproof method to eliminate all risks, remaining vigilant and conducting thorough research will definitely help you avoid the worst scams. Stay cautious and take care of your financial well-being.

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