4 Ways to Avoid a Ponzi Scheme

It seems like the SEC shutting down another Ponzi scheme has become a weekly occurrence. Ponzi schemes have been around since the 1920’s and are a fraudulent investment. They can be designed in many different ways. One popular design is for the first investors to be given the money that later investors put into the scheme. The scheme can continue until there are no new investors. Although the schemes can be hard to identify, there are several ways you can protect yourself from them.

1. Insure your portfolio is held at a third party custodian — This is the easiest way to avoid a Ponzi scheme. One way the promoter hides the scheme is by issuing fake or doctored statements. When your investments are held at a third party custodian, you will receive regular statements directly from the custodian. You can then compare what your investment advisor says to what the custodian says. Any discrepancies should be looking into immediately. Examples of third party custodians are Schwab, Fidelity, TD Ameritrade, Scott Trade, and Trust Company of America. If Bernie Madoff’s clients had demanded the use of a third party custodian, his scheme would have never worked.

2. Ask for the prospectus — You should always request a copy of the prospectus, which is a legal document detailing the investment. This document is required for most all investments offered in the US, and is filed with the SEC. You may not want to read through the entire document, but promoters of Ponzi schemes most likely won’t be able to give you the document because the “investment” isn’t actually an investment.

3. Be wary of consistent or higher than normal returns — Ponzi schemes often promote returns that are much higher than you can get in “regular” investments. If you see an investment consistently beating the market, be very cautious. Research has shown time and time again that investment managers can’t consistently beat the market. Consistent returns are also a red flag. If you see an investment earning 10 percent every year for 5 years in a row, something is wrong.

4. Trust your gut — Too many times, people that get suckered into Ponzi schemes express knowing the “investment” was too good to be true, but just couldn’t resist the promised returns. Trust your instincts when something feels wrong. If you are on the fence, consult a fiduciary investment advisor (that has nothing to do with the scheme or the promoter) that can be sure the investment is right for you.

The only guarantee a Ponzi scheme has is that it will destroy your portfolio. Very smart people have been duped into turning over their life savings in order to earn high returns, only to wake up and realize all of their money is gone. Trust your instincts to know that if it looks too good to be true, it is. And if you just aren’t sure, consult an expert that can help evaluate the investment.

So what do you think? Have you, or anyone you known, gotten duped into a Ponzi scheme? Have you ever been solicited to invest in one? What made you decide to invest, or not invest, in the scheme?