Most of us have probably heard of Bernie Madoff, who swindled lots of wealthy people out of tens of billions of dollars in the largest Ponzi scheme in history. He's no longer a danger, as he's serving a 150-year prison sentence now. There are other Ponzi schemers out there, though, who might cost us a lot of money, so it's smart to learn how to spot such schemes.
The Securities and Exchange Commission (SEC) wants to help, so it has listed seven warning signs on its website. First, though, let's define our terms. A Ponzi scheme is one that depends on money from new investors to pay existing investors. It's a scheme because the "investments" are not growing on their own because of savvy money management but because the one running the scheme is cleverly moving funds around behind a closed curtain. Once new money dries up, the schemer won't be able to pay all the investors what they've been promised, and the whole thing will implode.
Ponzi schemes can be quite enticing, which is why so many people have been suckered over many years. That's why you need to learn how to spot them -- or other iffy investments that share similar characteristics.
7 Ponzi warning signs
Here's a quick review of the SEC's warning signs:
Low risk, high returns: If you're presented with any investment opportunity that's described as offering very low risk and very high returns -- or, worse, that's "guaranteed" to deliver high returns, beware. In general, high potential returns are linked to high risk. That's just how the financial world works. Lottery tickets? High risk, high reward. Government bonds? Low risk, relatively low reward.
Very consistent returns: If you're offered the chance to invest in something that sports very consistent returns, take a closer look. Know that the stock market has always tended to go up over many decades, but from week to week and even year to year, its results are lumpy. Check out the S&P 500's returns over recent years in the table below. Clearly, any investment tied to the stock market is likely to feature varying returns. If you see returns that hardly vary at all, that should raise questions.
S&P 500 Return
Data source: Professor Aswath Damodaran, New York University.
Unregistered investments: When you invest, you should want whatever you park your hard-earned dollars in to be an investment registered with the SEC or with state regulators. As the SEC explains, "Registration is important because it provides investors with access to information about the company's management, products, services, and finances." Look into the registration status of any investment opportunity you're offered and don't just take the seller's word for it.
Unlicensed sellers: Speaking of sellers, know that people and companies in the investment business should also be registered, or licensed. It's required by federal and state laws. Verify the status of anyone you're dealing with.
If an investment is too confusing or mysterious, steer clear.
Complex and secret strategies: Another hallmark of many Ponzi schemes is that they feature complex and/or secret strategies. That's because, as they're fraudulent, their true nature shouldn't be apparent. It's common for you to be told that the amazing results of the investment are due to a secret investing strategy. Alternatively, you may be given an explanation that's too cryptic to understand -- possibly because it really doesn't make sense. Being too trusting can get you in trouble.
Paperwork problems: Solid investment companies tend to have solid reporting systems, issuing statements to you regularly. The statements tend to be relatively easy to understand and free of errors, too. If you're not getting statements on time or if you're spotting any errors or confusing things in them, that's not professional or reassuring. Take a closer look and ask questions.
Difficulty receiving payments: The SEC's last red flag is this: If you experience any trouble trying to withdraw money or you're not receiving any promised payments on time, you may be involved in a Ponzi scheme. Some investors who try to withdraw funds are urged to leave their money in place and in exchange are offered even better returns. Be critical and wary.
More signs of trouble
There are other signs of problematic investments you should be wary of. For example, beware of high fees. If your $50,000 investment grows by 10% in one year, you'll gain $5,000. But if you have to pay a 2% or 3% annual management fee, you'll be forfeiting $1,000 or $1,500 of that. Know that many great funds charge 1% or less, and many index funds charge less than 0.2%.
Any investment opportunity that seems too good to be true probably is. If a particular fund or stock is touted as being very likely to double your money within a year, ask yourself how reasonable that is. If it were really such a good investment, whoever is selling it would not need to be selling it, but just to invest in it themselves. Indeed, many of the world's savviest investors would have jumped in, and salespeople would not be required.
Speaking of sales people, if you're approached by anyone trying to sell you any investment, be wary. There are plenty of great investment opportunities in the stock market that you can find on your own or that you can read about. Simply investing in an inexpensive, broad-market index fund such as the SPDR S&P 500 ETF (NYSEMKT: SPY) , which distributes your assets across 80% of the U.S. stock market, is a solid long-term move, requiring little expertise or oversight.
It's good to be at least a little street-smart in life, and being a little Wall-Street-smart in your investing life can pay off well, too. Learn to recognize signs of trouble and you can avoid a lot of headache, heartache, and lost fortunes.
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