Too good to be true

I heard a saying a number of times growing up: if it sounds too good to be true, it probably is. This is a very useful guiding principle that will help you to avoid scams, but I wanted to talk about one that I saw in the news today, namely a Ponzi Scheme.

What is a Ponzi Scheme?

Named after Charles Ponzi, a Ponzi scheme is a fraudulent investment opportunity that relies on new contributions to pay the returns promised to earlier investors. The model falls apart when there aren’t sufficient new investors to keep the cashflow going, meaning either the promised returns are extremely high or the pool of potential new investors is not large enough to address the demands of the scheme.

Until the scheme fails, it often actually does what it promises, so it is absolutely vital not to rely solely on data that shows some people have actually achieved the returns promised. They could well be some of the early adopters that are then used to entice further contributions from others. 

A Typical Ponzi Scheme

You might see an advert for a scheme guaranteed to double your money in a year.  It sounds like a great return, so you hand over your investment of £100,000 and wait to be rich after some compounding. Months go by and you get periodic update of how your portfolio is performing. Updates look good through the year, with returns in line with what you were promised, and  you get close to the maturity date.

At this point one of two things happen. If you are early enough in the scheme, you might actually get your promised return. You put in £100,000 so you might now have £200,000 if the promise was to double your money in a year. This “return” is funded from other people liking the look of the offer and paying in.  If 5 other people also decide to invest £100,000 each, that easily funds your “return”, plus a healthy profit margin for the scheme organiser.

But what happens if the scheme starts the year with 5 investors and only attracts 3 new ones? In that case, paying the £100,000 gain plus the £100,000 initial stake for each of these investors would cost the scheme £1 million (remember, your own investment isn’t sitting in their custody, it’s already been used to pay for someone else’s return).  Suddenly the scheme needs to find £1 million but has only attracted £300,000. The result? Total collapse, at which point liquidators will likely end up being called in, and they will determine quickly that the scheme was fraudulent. If you’re lucky, you might get back a tiny fraction of your initial stake, but after all the costs of unravelling the scheme, this is very unlikely.

Why Does This Happen?

The simple answer to this is that it happens because it is inevitable. The entire basis of operation for a Ponzi scheme is to use current contributions to fund the returns of previous investors.  On this basis, if the return being promised is a doubling of the value, then n initial investors require 2n new investors to allow the scheme to break even, which would leave nothing for the organisers and so is likely wildly lower than required.

For those in the know, this is a very classical mathematical example of exponential growth. If the scheme starts with just 1 investor – highly unlikely – then by the 10th generation you’d need to find 512 new victims to keep the scheme going. By the 20th generation, that number would climb to 524,288. By generation 30, the total number of participants would need to be 536,870,912, more than the population of most countries. And it only continues to grow.

At some point, the scheme will be unable to find sufficient new money to fund the maturing accounts, and that signals the collapse of the scheme. 

Importantly, this applies regardless of the promised returns if the returns are always funded from new money. As an example, it would be possible to structure a scheme like this to only pay 1% after a year, which sounds innocuous enough and could probably be converted profitably into a sound investment scheme, but if it is funded solely from new money the collapse is guaranteed at some point in the future – albeit at a very slow rate. My calculations show that such a scheme would require 434,963,837 new investors by generation 2000.  As such, it would take a long time to fail, but the eventual failure is guaranteed if it is structured as described.

How Do I Avoid Ponzi Schemes?

This is hard to say explicitly because the people who structure these schemes are very good at disguising the way the scheme actually works (or doesn’t, as outlined above). However, a few things definitely help:

• Take professional advice from a regulated financial adviser. This way even if what you invest in turns out to be a fraudulent scheme, the adviser has a degree of legal responsibility and you have the protections of the Financial Ombudsman Service (FOS) and the Financial Services Compensation Scheme (FSCS).
• Invest on a well-known platform that is not controlled by the scheme itself. Again, platforms will be regulated and they will have a certain level of responsibility for the investments places on their platform.
• If you don’t understand where the returns are going to come from, don’t invest. This won’t help if the scheme promoter outright lies to you about where the returns are coming from (e.g. Bernie Madoff), but it will rule out some of the schemes that target you.
• Unless you have a very good reason to do so, stick with standard regulated funds. These include Unit Trusts, Open-Ended Investment Companies, Investment Trusts and Exchange-Traded Funds. You can also consider buying direct shares or bonds, but most investors simply do not have the necessary level of information or research time to warrant that approach.

If you want to talk more about a scheme you have been invited to join or if you just want to talk more about your own finances and options please get in touch.