What are ponzi schemes and how to avoid them

A 50% profit in 45 days. Sounds too good to be true, right? Well, that’s exactly what the infamous Charles Ponzi offered to his ‘investors’ back in 1920¹. If it’s not already clear, investors did not receive those promised returns. Instead, they were the victims of what we now call a Ponzi scheme.

In the first four months of this year, over $205 million has been lost to investment scams – a 166 percent increase over the same period in 2021, according to new data from Scamwatch². With Ponzi schemes receiving renewed attention in the popular media with the release of the new Underbelly series about Melissa Caddick, we thought it would be a good time to look at investment scams (and Ponzi schemes in particular) and how investors can avoid them.

Expect to see more articles like this in the months ahead, as we turn our focus on financial literacy, investor psychology and the basics of investing.

What is a Ponzi scheme?

A Ponzi scheme is a type of financial fraud where recent investors’ money is used to fund the ‘returns’ of early investors. Generally, there is no underlying investment being made, and the money received from investors is fraudulently used by the scheme operator to fund their lifestyle.

However, some of the biggest and most famous Ponzi schemes of all time did have a kernel of truth at their core. Charles Ponzi’s original scheme, for example, was based on “a kind of smart investment idea. Albeit one that could not have been run on any real scale,” according to Patrick Boyle, Professor of Finance at King’s College London³.

Examples of Ponzi schemes from recent years

Perhaps the most well-known Ponzi scheme of recent years was run by Bernie Madoff. The massive scheme was worth nearly US$65 billion⁴. In 2009, Madoff was sentenced to 150 years in prison⁵, though he served just 12 of those years before dying of a chronic kidney disease in 2021⁶.

Closer to home, Melissa Caddick allegedly stole $23 million from investors in a scheme that ran between 2012 and 2020⁷. Caddick has received significant press coverage in recent months after her spouse, Anthony Koletti, objected to the sale of their home, with the proceeds due to be used to pay back investors⁷. If you’re a fan of the Underbelly series, you’ve no doubt seen their dramatization of the events too.

5 tips to help you avoid the next Ponzi scheme

Ponzi schemes have been around for over 100 years and they’re unlikely to disappear anytime soon. So here are a few tips that could help investors avoid falling victim to the next swindler.

1. Do your research

If someone claims to be a financial adviser, this can be easily verified. ASIC’s Moneysmart website provides access to a Financial Advisers Register that allows you to check if a person is authorised to provide financial advice. You can also check if an adviser has been banned or disqualified using ASIC Connect.

A licensed adviser has a responsibility to act in the best interest of their client, which includes doing appropriate research on any investment they recommend and making sure the advice they provide meets their client’s objectives, financial situation and needs.

Funds that are available to trade on an exchange such as the ASX are required to comply with strict regulatory and other requirements. While this is no guarantee of investment performance, it does provide strong regulatory protections for investors.

2. Be sceptical

Be suspicious of ‘recruitment’ and high-pressure sales tactics. Often this will involve a referral from a neighbour, family member, or friend. They may tell you that they’ve already invested in the scheme and have received unusually high rates of return.

Other than paying the usual advice fees, you shouldn’t write out cheques to an adviser or intermediary, or send money directly to their personal account. Generally, the money you are investing should be sent directly to the platform or broker and the account should be opened in your name.

3. Check in with your service providers

Call your broker or platform operator directly to check the bank details you’ve been provided are valid and that you actually hold an account with them.

Caddick claimed her clients’ funds were held with CommSec, but the account numbers were invalid⁶. Contacting CommSec would have likely made it clear that the clients held no account with them.

4. Explore ASIC’s Moneysmart website

Not only does Moneysmart provide information on avoiding Ponzi schemes and choosing a financial adviser, but it also provides useful calculators and guides covering all aspects of your financial life.

Whether you want to learn about saving for an emergency fund, or estimate how much money you might have in your superannuation at retirement, Moneysmart offers a variety of helpful resources.

5. The golden rule

‘If it seems too good to be true, it probably is.’

High returns generally come with higher risk, and low risk investments tend to have lower potential returns. If you’re being offered great returns at ‘low-risk’ or ‘no-risk’, this is a good indicator that something isn’t right.

Life changing returns are incredibly rare, and those that have found a way to achieve them rarely share their secrets. A simple ‘sniff test’ can go a long way.