We have never been short of ponzi schemes and that too innovative ones. These scams are not restricted to the usual asset classes; they have taken into their fold the animal world (the emu scam) and the plant kingdom (teak plantations).
The latest to hit us, the Saradha Chit fund scam, though, is relatively a less dramatic but equally painful story of people losing money to ponzi schemes.
Old wine new bottle
Whatever the nature of the scheme, the underlying story is always the same: promise of very high returns; such returns actually get paid initially; more investors are attracted by word of mouth; until new investments stop and the scheme crashes for want of fresh money to pay existing investors.
Why do these Ponzi schemes-turned-scams crop up time and again? Experts point to a lack of a widespread and formal financial and banking system. This may be true of the Saradha Chit Fund case where a number of people from town and villages, perhaps having little or no access to regular means of finance, put their hard earned money in the chit.
And yet, large cities do not lag behind either, when it comes to being conned by ponzi schemes. The fraudulent act by a Citibank relationship manager on high net worth clients including promoters of a large auto company as well as a venture capitalist was by no means due to poor financial channels.
Thus, it makes us believe that the promise of high returns can often times overpower simple financial wisdom. Needless to say, it is the retail investors who mostly fall prey to these schemes.
The fear of loss in equity market and the lack of inflation-beating returns from regulated fixed deposits push investors into taking a higher risk – the risk of losing all their savings and having little or no redressal mechanism.
Here are a few points that may be worth giving a thought if you ever come across a scheme that lures you with high returns:
Complicated business or investment strategy
Ponzi schemes often work in multi-tiers. They are called pyramid schemes and often take the structure of multi level marketing (MLM) agencies. In a 2009 circular the RBI had brought to light (see RBI notice) as to how some of these firms posing as MLMs had been mobilizing large deposits with money eventually following out for illegal or highly risky purposes.
Therefore, it is first important to understand the nature of business or investment strategy.
If somebody is trying to sell you a product or idea that you do not understand, it is not your fault. It is the likely that the idea is a weak or dubious one. Walk away.
It is best to seek opportunities in businesses that have existed for a good period. Even if the business appears promising , remember retail investors cannot be angel investors, providing finance to budding businesses that hold plenty of promises and no assets.
High ‘guaranteed’ returns in short span
High returns mean high risk. This funda especially holds good if returns are promised in a short period of time. Take the Gold Sukh case where the promoter promised 150% returns in 18 months. A fixed deposit would take over 10 years (at 9%) to deliver that. Nor did gold deliver such returns in that period. In the Citibank relationship manager’s case, investors were promised 2-3% a month. That’s about 24% a year.
Now that does not mean one cannot earn 20-30% in equities or mutual funds. You can but they are neither guaranteed nor predictable. Also there is an underlying core business of a company involved in all this.
Hence make a quick back of the envelope calculation to check if such returns are feasible at all in relation to regular products available in the market. A novel scheme (like the plantation schemes when they were first launched) that cannot be compared is good for promoters to make their windfall gains (if there really is); not for you.
Also, whether in gold, equities or currency trading, be wary of ‘assured return’ schemes that ask you for a lump sum with promise of high profits. If you wish to trade, you better learn to do it yourself using your own demat and broker account. There can be no other recipe for disaster than these purported pooled schemes.
Regulations governing the scheme
Large returns mean larger risk; that entails huge amount of information and verification before you invest. The first step towards such verification is knowing what laws govern the investment. It could be the RBI or SEBI or simply the Companies Act.
You should also know if the firm has authorization to borrow from the public. For instance, an NBFC must be registered with the RBI and also have authorization to collect deposits from the public. They are also required to have a credit rating on such deposits.
Direct equities and mutual funds are governed by SEBI laws while insurance by the IRDA. Chit funds, on the other hand, are mostly governed by state laws (not by RBI) and have less redressal mechanisms when compared with the others mentioned above.
You need to know if you have a lifeguard before you get into the waters.
High initial investment
As ponzi schemes seldom have their own capital, they would depend on investors to invest a good sum in the beginning or in a matter of few instalments. Gold Sukh had 3 such plans of Rs 23,000, Rs 1.2 lakh and Rs 6 lakh. That is a large sum for a retail investor. Be wary of committing large sums in schemes outside the ambit of regular organized financial system.
Do not go by the high returns that a friend just received from a ‘too good to be true’ firm. That’s how a ponzi operates.
Economist Robert Schiller’s definition of ponzi scheme in his research paper is now being often quoted in the media: “It (ponzi scheme) creates a false perception of high returns for initial investors by distributing to them money brought in by subsequent investors. Initial investor response to the scheme tends to be weak, but as successive rounds of high returns generate excitement, the story becomes increasingly believable and exciting to investors. Finally, the scheme collapses when new investors are not prepared to enter the scheme”.
There could be any number of other clues that should spell caution. A firm demanding payment through third party or individual’s name, the promoter promising to pay back from his own pocket (no institution is going to promise that) or schemes that make you feel important by stating ‘exclusive’ offers. The list does not end there.
No quick bucks
In all, scams time and again bring to light that there is no such thing as quick money. As investors, we have little choice but to start building investments early, if we aim high.
For retail investors the only recipe to build wealth is: making regular investments through regulated systems, taking calculated risks and seeking the help of qualified people in case they need advice.