How to Avoid Getting Duped in a Ponzi Scheme

Nearly a decade after Bernard L. Madoff made off with some $64 billion of investors’ money in one of the biggest Ponzi schemes in U.S. history, people are still falling for scams and losing the savings they worked a lifetime to build.

You’ve heard the term Ponzi scheme, but maybe you don’t know exactly what it is and how it works. Basically, it’s an investment fraud that pays existing investors with funds collected from new investors. There’s usually the “guarantee” of high returns with little or no risk. In reality, often the fraudsters never even invest the money. Rather, they use it to pay earlier investors, put some in their pockets and continue playing the game, finding new pawns to ensure cash flow.

This can go until they can no longer find people to dupe, too many folks cash out, or the crooks get busted by authorities. In case you’re wondering why it’s called a Ponzi scheme, it’s named after Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s.

What are red flags?

Truth is, sometimes the handwriting is on the wall, but you just don’t recognize what spells T-R-O-U-B-L-E.

“The biggest tip that can help consumers avoid Ponzi schemes is to understand the relationship between risk and return,” says Jacob Lumby, a certified financial planner and founder of cashcowcouple.com. ”The entire investment universe is founded on the relationship between risk and return.”

If an investment promises a higher expected return, you should expect that investment to carry some risk and vice versa. For example, explains Lumby, savings accounts pay very little interest because they are virtually risk-free. On the other hand, the stock market has provided an average annual return of roughly 10 percent over the last century, but in return for that higher average returns, investors had to endure periods of severe volatility that may have cost them money. The higher expected return is correlated with the risk involved.

A key feature of many Ponzi schemes is that an investment adviser promises all the rewards but mentions no risk.

“If a Ponzi scheme offers an outlandish guaranteed return, while also promising to be without risk, that is a major red flag,” Lumby says.“There are no free lunches in the investment world, and if something sounds too good to be true, it probably is.”

The U.S. Securities and Exchange Commission offers some insights on warning signs:

Overly consistent returns. That just doesn’t make sense, does it? It’s like someone hitting home runs every trip to the plate. Steroids perhaps? Something’s up.

Secrecy about how your money’s invested. The same goes for an adviser who is overly vague if you ask questions about where your money is going, or he or she explains it in a way that is so complex it makes your head spin. The fraudster may be a little shaky in presentation and mostly stresses that this investment is “the next big thing” that “few people know about.” If you can’t understand or can’t get complete information, don’t assume the adviser simply knows more than you do. Keep asking questions.

Shoddy paperwork — or none at all. Read those investment reports closely; don’t just leave them in the pile of junk mail. And get nervous if the paperwork seems shoddy. According to the SEC, account statement errors may be a sign that funds are not invested as promised. Be suspicious, too, if you don’t get paid when you’re supposed to, encounter obstacles when you try to cash out, or are offered even higher returns for staying in the game when you decide you want out.

Expect all sorts of tricks

Be mindful too, that Ponzi schemes come in many varieties, and don’t just involve stocks. Take, for example Bitcoin. There was a case, SEC v. Shavers, where the organizer of an alleged Ponzi scheme advertised a Bitcoin “investment opportunity” in an online Bitcoin forum.

Investors were allegedly promised up to 7 percent interest per week, and were told that the invested funds would be used for Bitcoin arbitrage activities in order to generate the returns. Instead, investments were allegedly used to pay existing investors and exchanged into U.S. dollars to pay the organizer’s personal expenses.

Even plain-vanilla investments like certificates of deposit can be used by scammers.

Protect yourself

A good rule to follow is to always diversify your investments. If any advisers is asking you to put all your eggs into one “sure thing” investment, walk away. The point of diversification is that all your assets aren’t tied up in one thing, which would leave them highly susceptible to any volatility.

And if you don’t want to get played, stay alert. Listen to your instinct. Trust your gut. If something doesn’t feel right, you’re likely not wrong, so don’t let greed get in the way of wisdom. Be paranoid: Somebody may be out to get your cash.