6 Tips to Avoid a Ponzi Scheme

February 3rd, 2011. By Kristine B

They are two words that no investor wants to hear: Ponzi scheme. As in, your money was invested in a Ponzi scheme. People whose money winds up in a Ponzi scheme often have a lot of difficulty getting their money back, especially if they were among the last to invest. There are ways to watch for Ponzi schemes and avoid them. These tips won’t guarantee that you’ll never invest in a Ponzi scheme, but they’ll at least help to reduce the likelihood of it happening.

What is a Ponzi Scheme?

A Ponzi scheme is an investment scheme in which money from new investors is used to pay out previous (or existing) investors. So, when I invest in the scheme (unknowingly, of course), my money is used to pay the would be “ROI” (return on investment) to the people already invested in the scheme. So, in other words, very little real investing occurs. The Ponzi scheme collapses when one of three things happens: there are not enough new investors to pay out previous investors; when large numbers of previous investors demand to be paid out; or when someone becomes suspicious about where the money is coming from. In recent times, the Bernie Madoff Ponzi scheme made headlines—and Carr Miller is now facing allegations of a Ponzi scheme as well.

The Downside of Ponzi Schemes

Because the money isn’t really invested as it’s purported to be, the scheme requires new investors to keep it going. But those new investors, if no one else invests after them, won’t get their money back. Their money has either gone to previous investors or has gone to fund a lavish lifestyle on the part of the person in charge of the scheme. Nice, huh? All your hard-earned money just bought some guy a fancy car and a trip to a luxury resort, while you thought it was sitting in honest investments.

Even previous investors who were paid out might not be safe. Why? Because the money they were given was illegally gained. So they might have to give some or all of it back to a trustee who then determines how to split up whatever money remains—if any does.

How to Avoid Ponzi Schemes

1) Don’t invest with someone just because your friends/colleagues/associates do.

There’s no guarantee that they’ve done their homework about an investment. Furthermore, if the seller is part of that group, it’s likely everyone trusts this person and won’t have checked into his past or his investments. Many folks who run Ponzi schemes target people who go to their church or belong to their country club.

Yes, you can take the referrals of people you know. But you have to research the referrals. Find out why your friends like the seller, what their financial plan is and how they are paid their dividends. Check with professional organizations for information about the seller.

2) Don’t believe the hype.

If something sounds too good to be true, it almost certainly is. Many Ponzi schemes offer ridiculously (and sometimes impossibly) high return rates that seem to operate independent of market conditions. If someone promises you returns of 35 percent when everyone else is getting three or four percent, something’s not right.

3) Don’t invest in anything you don’t understand.

You might not be a seasoned investor but you should be able to understand where your money is going and how it will make money for you. Ask questions and don’t let the seller dismiss your concerns. Make sure you understand exactly what’s happening to your money. If the seller doesn’t have decent answers or you don’t understand the investment, walk away.

4) Don’t invest everything with one person.

If you invest with two people not only are you diversifying your investments, you’re reducing the likelihood that you’ll lose all your money. Yes, it takes time and effort, but if you invest everything with one person and that person is a con artist, you’ve just lost everything.

5) Don’t let the seller have complete control of the money.

Make sure your money is held at a qualified, third-party (meaning, not under the control of the seller) custodian. That limits the control the seller has over the money.

6) Don’t make emotional investments.

If you’re excited about the investment, take some time to go over the details and ensure they make sense. Don’t believe sellers who say you’ll be part of an elite group when you invest your money—the only elite group you’ll be part of is the group of people desperate to get their money back when they find out they’ve invested in a Ponzi scheme. When you get emotional about an investment, you’re less likely to ensure you’re protected.

What can you do to prevent investing in a Ponzi Scheme?

Research, research, research. Learn about finances. Ask questions and demand sensible answers. Don’t let anyone tell you that you shouldn’t get caught up in the details—because the details are important. Demand to see the paperwork—the prospectus or disclosure statement—before investing. You don’t have to be an expert about all aspects of investing, but make sure you understand the basics, so you can tell when something doesn’t seem right.

If the seller gives the names of various companies that you would be investing in, look those companies up to ensure they really exist. Check with the SEC to ensure the investment is registered. Check to ensure the seller is licensed.

Understand your investment style and make sure your financial seller respects that style and your risk tolerance. 

The Securities and Exchange Commission (SEC) lists five questions every investor should ask when considering the next investment opportunity:

1) Is the seller licensed?

2) Is the investment registered?

3) How do the risks compare with the potential rewards?

4) Do you understand the investment?

5) Where can you turn for help?

For information about licensed sellers or registered investments, the SEC has a toll-free investor assistance line at 800-732-0330.

Tags: Ponzi scheme, Securities Fraud

This was posted on Thursday, February 3rd, 2011 at 4:55 pm and is filed under Emerging Issues, Pleading Ignorance, Securities . Feel free to respond, or trackback. Read our comments policy.