Ponzi schemes—like the $50 scam allegedly run by Bernard Madoff—have been around for decades and, unfortunately, will likely continue to exist for years to come. Here’s how to recognize a potential Ponzi scheme and avoid getting burned.
What is a Ponzi scheme?
A Ponzi scheme, named for early 20th century con artist Charles Ponzi, is a kind of investment fraud in which a con artist takes money from new investors in order to pay existing investors “returns”. Since the money is never invested, however, investors are never actually earning new money, they are simply taking money from other victims. If the fraud is not discovered, the Ponzi scheme will eventually collapse if the con artists cannot recruit enough new investors to continue paying old investors, or when enough investors demand their principal back.
How to spot and avoid a Ponzi scheme
Recognizing and avoiding a Ponzi scheme or other investment fraud comes down to doing your homework and maintaining a consistent level of skepticism. First, make sure anybody you entrust with your investments is legit. Check their credentials as a financial planner, accountant, or investment adviser with the appropriate agencies.
Don’t stop there. Ask to see your investment adviser’s ADV Form which is required by the Securities and Exchange Commission (SEC) for advisers managing more than $25 million. This form will tell you about the adviser’s education, business, fees, investment strategies, and any disciplinary actions in the last ten years.
Be wary of managers that also want to be your custodian. Custodians are broker-dealer firms like Fidelity, TDAmeritrade, or Charles Schwab. These firms maintain your investment account and issue statements at least quarterly. A manager, on the other hand, helps you make decisions about where to invest your money. Some managers may actually make transactions for you, in which case they would ask that you write checks directly to them for the amounts you wish to invest. Proceed with caution. Although some trustworthy and legitimate money managers may do business this way, those money mangers should not have a problem if you wish to write checks for investments directly to the custodial firm.
Understand your investments. One of the most simple rules of investing can help you avoid Ponzi schemes and other investor fraud. If you don’t understand an investment—or your money manager can’t adequately explain an investment, stay away.
Finally, diversify. I am willing to bet that failing to diversify one’s investments has ruined more investors than any other single mistake. If you diversify properly, even if you should somehow invest part of your money in a Ponzi scheme or another scam, you’re protected. Yes, losing money is never a good thing. But I’d much rather lose 5% of my money than all of it. No matter how good an investment seems to doing, never invest everything one place.