Ponzi Schemes -Spotting a deal that’s too good to be true

Contribution by Viv Govender – Vunani Private Clients

In 1920 an Italian American called Charles Ponzi was running a company called the Securities Exchange Company. Mr Ponzi had come up with a scheme that was supposed to return 400% on your investments. This was vastly more than you would get at any bank and thus attracted much attention. At its peak he was taking in $250 000 per day. This works out to about R25 Million in today’s money after taking into account inflation. Eventually Ponzi’s business imploded and it emerged that there was no legitimate business model behind his company.

The scheme effectively worked as follows. Mr Ponzi would collect investments for his scheme, promising to give massive returns, 50% in 45 days. He would pay out these returns with the money from new investors. As long as more investors came in, the scheme appeared legitimate. However this could not last forever and when the growth of new investments dried up, he no longer had the cash to pay his older investors. He eventually went to prison for several years and died in poverty, but his name lives on in the term Ponzi scheme.

Only a few years ago another American, Bernie Madoff, created a similar scheme. The amounts were vastly larger, hundreds of billions of Rands, but the basic idea was the same. Pay of older investors with money from new ones.  In fact this simple idea has found to our own shores in South Africa. A recent Ponzi scheme involved as much as R10 Billion and defrauded some of the biggest names in the South African business sector.

So how can you avoid losing your money to these conmen? The simple answer if something looks too good, it is likely a scam. In economics we have a term called the risk free rate. This is the best return you can get with no risk. If you get a return that is better than this, you are taking some risk. The greater the return, the greater the risk you are likely taking. Therefore if someone comes to you offering super high returns, they are also offering super high risk. Guaranteed.

It is easy to see why this is if you look at the situation from the other side, from the point of view of the person selling the investment. If the investment is real then he has a business idea that makes a profit but not enough money to get it started. So he is looking for investors to finance his business. He has a few options including the banks, professional investors and you. The bank will charge him prime plus a few percent, the professional investor a similar rate but he is offering to pay you much more than this. Why would he make such a silly decision?

Perhaps he tells you that the banks and professional investors don’t understand or believe in his idea, but if this is the case why should you believe in him. Do you think that you are better at understanding investments than the professionals? Even if this were true, the investment should be a once off opportunity. Once the owner of the business has been running for a little while, he should be making so much money that he would be able to pay you off and carry on funding the business from his own profits. He should never be looking for yet more investment.

I hope that this article helps you to avoid being taken in by crooks like Mr Ponzi. If you are ever approached to invest in a scheme that offers massive returns, please feel free to contact me at viv@vunaniprivateclients.co.za.  I will be happy to help you evaluate whether it is a legitimate investment.

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