With the current condition of the economy, there have been a couple ponzi schemes that have unraveled, leaving investors wondering what happened to their money. Two high profile investment frauds in Canada had been orchestrated by Earl Jones and recently Gary Sorenson.
Before Bernie Madoff was busted in the United States, no one had heard of Ponzi schemes to their recent recollection. Now I see it's even the subject of a recent episode of CSI: Miami and tonight's episode of The Border.
So what exactly is a Ponzi scheme? It's a scam where current investors are paid a return from the money paid by new investors. For example, say someone promised a 25% return and they gave the advisor $100,000. When the time comes to pay, the early investors would get that $25,000, but it wasn't from some great investment decisions, it was simply from the newer investors since then. If one new investor also put in $100,000, that could possibly pay two earlier investors their return and the advisor could pocket the remaining $50,000.
This can go one for some time, especially if the investors want to reinvest their money. Going back to the original investor that gave $100,000. What if he wanted to reinvest the $25,000? This is even easier for the advisor, he can simply print a statement showing a balance of $125,000 for the investor and in reality there may be none of that money left.
Another way to prolong this fraud is to “guarantee” a higher rate of return when locking in for a longer period of time. Instead of 25%, maybe the advisor would offer a 35% annual return if the money is left in for 10 years.
So why are we hearing about all these investment schemes falling apart now? Two things happened because of the current economy with the majority of investors, not just those caught up in a ponzi scheme. First, there where no new investors and secondly, current investors wanted their money out due to the fear of the market. When this happened the bottom fell out on these scams, there was no more money to pass up to the previous investor. This lead to most of these scam artists grabbing whatever money was left and going into hiding.
Hopefully all the media attention will serve as a reminder to check out your financial advisor, know what it is that your advisor is investing in, and question returns that seem too good to be true. The best way to know your advisor will put your interests first is to choose a fee-only financial planner. Better yet, drop the advisors completely and invest in index funds by yourself.