The 1920s are known as the “roaring twenties.” One reason for this is that the stock market was booming and it seemed like money was there for the taking. A man named Charles Ponzi certainly thought so: At the very start of the decade he was working a fraudulent investment scheme, which continues to bear his name. In recent times, the most famous “Ponzi Scheme” was conducted by Bernie Madoff, who was arrested in 2008.
Even though Ponzi schemes are well-known, their promised superior returns–frequently marketed with compelling stories–consistently find victims. For example, recent statistics have tracked between 40 to over 100 different Ponzi Schemes occurring every from 2008 to 2013.
Each Ponzi scheme can affect numerous families. Significantly, Ponzi schemes are not the only form of financial fraud that can devastate personal savings. For example, the financial frauds that caused the failures of Enron and Worldcom in the early 2000s also devastated numerous individuals’ savings. In fact, financial fraud is so common that a television show called American Greed was created to profile select frauds.
One thing just about every episode of American Greed has in common is the profile of everyday people who were swindled out of their savings. How, then, to avoid financial fraud or at least mitigate its effects?
Step 1 is to adopt the mindset of every successful professional investor that I know: Radical skepticism. Fraud claims victims because the stories fraudsters tell are compelling. Therefore, if you start out–and remain–highly skeptical as you investigate an investment opportunity, you mitigate the risk of being “sucked into” a fraudulent story.
Step 2 involves finding out why “you” have been presented–or targeted–with a particular investment opportunity. If you are not wealthy, you likely do not have money you can comfortably afford to lose. As such, you should generally have large corporations invest for you, absent a very compelling reason. Professional corporations have large assets of their own, and ample amounts of insurance coverage as they know they will be sued if things go wrong.
Step 3 involves basic benchmarking. Warren Buffett, the Chairman and CEO of Berkshire Hathaway, is one of the most successful investors in history. He posts all of his shareholder letters on-line for free (http://www.berkshirehathaway.com/letters/letters.html). If you click on his 2014 letter, the first page that opens is a benchmarking page, which shows the annual percentage changes in Berkshire’s net assets and stock price, as well as the S&P 500.
If an investment opportunity you are evaluating outperforms any of these benchmarks, find out specifically why. If, while doing so, you come to believe you have stumbled onto “the next Warren Buffett,” you should know that there is a greater chance of winning a Powerball lottery than there is in finding “the next Warren Buffett.” Therefore, you should remain very skeptical (see Step 1).
If you get this far and still want to make an investment, Step 4 holds that you only invest a small amount of your money, so long as it can be comfortably lost. An absolute rule of personal finance is that you never put your home, livelihood or savings at risk from any investment. This is a “fail safe” in that if an investment fails, as many investments do, the loss you suffer will not be catastrophic.
If, after making an investment, you come to suspect that you may have been defrauded, Step 5 holds that you immediately contact the authorities. The sooner you do so, the sooner you may be able to get your money back, and bring the fraudster to justice.
How Ponzi Schemes work: Act Now