How to identify a Ponzi scheme

Person holding fraud poster

Having recently watched Madoff: Monster of Wall Street which is currently airing on Netflix, it’s difficult to believe the duration and devastation of Bernie Madoff’s Ponzi scheme – and that so many people fell blindly for the scam. Madoff, who operated his Ponzi scheme behind the façade of a legitimate investment advisory business, managed to convince clients to invest in his scheme which collapsed, as all Ponzi schemes eventually do, in 2008 with an estimated loss of $65 billion. While everyone likes to think they’re immune to investment scams, the numbers tell a different story – with thousands of South Africans being conned by new Ponzi schemes every year. In this article, we explore the mechanisms of a Ponzi scheme and how to identify the red flags.

Named after the 1920s fraudster, Charles Ponzi (who promised investors in New England a 40% return on their investments in 90 days, compared with 5% interest earned in savings accounts) the Ponzi scheme is the oldest and most common type of investment fraud. In its simplest form, a Ponzi scheme is a pyramid scheme that operates on the basis of ‘robbing Peter to pay Paul’. The promoter (i.e. the person setting up the Ponzi scheme) pays the initial investors sizeable returns using the investments of subsequent investors rather than from business profits. Ponzi schemes generally have no viable business model and very rarely generate any legitimate profits of their own. Their survival is dependent on a constant flow of new investor money which, if not found, will result in the ultimate collapse of the entire swindle – which is what happened to Madoff’s scheme in the 2008 stock market collapse.

A Ponzi scheme can take any shape or form – depending on the inventive imagination of the promoter – and can be run by anyone with an inclination for fraud. In most Ponzi schemes, the promoter and early investors inevitably make the most money and live lavish lifestyles, whereas the later investors inevitably lose everything. In the early stages of a Ponzi scheme’s existence, the promoter pays out high returns ‘as promised’ in order to build trust with the early investors and encourage new investors. Once the supply of new investors inevitably dries up and the promoter is unable to pay out returns, investors become suspicious and distrustful.

Sadly, investors are often slow to admit that they’ve fallen victim to a Ponzi scheme. Besides the understandable anguish of being perceived as both foolish and greedy, many fear that public exposure will create a crisis of confidence that could create a run on the promoter and make matters worse. Clinging to even the smallest fragment of hope, investors have been known to go to enormous lengths to protect the promoter in the hopes that they can recover some money. When it comes to investing, it is advisable to exercise great caution and look out for any of the following warning signs:

  1. Abnormally high investment returns

The most obvious sign of any fraudulent investment scheme is the promise of abnormally high investment returns. While Ponzi schemes may take a variety of forms, they all follow the same intrinsic theme: investors are promised they will make a much higher return than can be achieved through any conventional investment opportunity.

  1. Guaranteed returns

The words ‘guaranteed returns’ are designed to trigger both deep-seated investor greed and the willing belief that this is a ‘sure-fire thing’. However, when it comes to investing, no return is ever guaranteed and even the most modest investment carries some risk. Keep in mind that greed is your greatest enemy when investing. Be highly suspicious of anyone who offers you a guaranteed return on your investment.

  1. Consistently high performance

By their very nature, the investment markets rise and fall over time, and your returns in any reputable investment will reflect these market fluctuations. Be sceptical of any investment that promises consistently positive returns regardless of overall market conditions.

  1. Vague business model

If you don’t understand the business model after a 5-minute explanation, stay away. The investment’s business model should be easy to understand and, as an investor, one should be clear about where and how returns are generated. Fraudsters are notorious for using complicated verbal constructs such as ‘hedge future trading’, ‘high yield investment’, and ‘offshore investment program’ in order to intimidate would-be investors. These are smoke-and-mirror tactics used to confuse and bully investors.

  1. The need for more investors

The survival of any Ponzi scheme is dependent on its ability to continually attract new investors. Without an ongoing stream of new investors, the promotor is unable to pay the previous investors, and the whole scheme will unravel. Be skeptical of any investment scheme that pressures you to find new investors, or which offers rewards for introducing new investors.

  1. Pressure to reinvest

Ponzi schemes will collapse without regular income or if too many investors withdraw their funds at the same time. In order to remain afloat, the promoter will offer investors higher returns if they don’t cash out or if they reinvest their money. While on paper investors believe their investments are gaining incomparable ground, the truth is that most Ponzi schemes don’t make any investments on behalf of their investors at all. If you’re pressurised or rewarded for reinvesting, be alarmed.

  1. Pressure to act now

Ponzi scheme promoters are also notorious for creating a false sense of urgency by leading investors to believe the deal is only valid for a limited period of time. The investment opportunity is often shrouded in secrecy, and investors are pressurised to ‘act now’ while the ‘once-in-a-lifetime’ window of opportunity stands obscurely and suspiciously ajar. Pressure to invest within a certain period of time is foreign to sound investing principles and should be considered a major red flag.

  1. Credibility through association

Evidenced by Madoff’s modus operandi, Ponzi scheme promoters generally create an air of exclusivity by luring would-be investors into their inner circle of family and friends. Investors’ fears are allayed by the proximity of those close to the promoter because, after all, thieves don’t rob from their own homes. Madoff, in fact, managed to hide the Ponzi scheme from his own sons – one of whom later tragically took his own life.

In challenging economic times such as we find ourselves in as a result of rising costs of living, loadshedding, high unemployment, and escalating interest rates, it’s inevitable that an increasing number of South Africans are becoming financially desperate and more susceptible to investment scams. Desperate to get out of debt and escape their current financial dilemmas, the idea of making large amounts of money in a short period of time is difficult for many to resist.

If you’re unsure whether an investment is legitimate or not, our advice is to remain composed and do your due diligence. Remember, there should be no urgency or pressure to invest, so take your time to do your research. Ideally, contact an independent financial advisor who should be in a position to give you objective advice.

Have a super day.


Let's talk

For a free consultation with no obligations, please fill in your details and we will contact you to set up a meeting.