Don't get fooled: things to watch out for to avoid investment scams

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11 December 2023

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Important: This article was originally written by Finimize. Any opinions offered are those of Finimize and not of CMC Invest.

This information is for guidance purposes and may become out of date at any given time. It is not investment advice. Investments can rise and fall in value. CMC Invest won’t make any assessment of whether the investments you choose are appropriate or suitable for you. If you are unsure of the suitability of any investment, investment service or strategy, you should seek independent financial advice. Past performance does not indicate future results. Your capital is at risk.

Ponzi’s scheme

This article is all about how to spot dodgy deals. We’ll show you the lessons you can learn from history’s biggest scammers – like Charles Ponzi and Bernie Madoff – so that you can avoid falling prey yourself.

Who was this Ponzi guy? Let’s go back to the New York of 1920. The roaring twenties – a.k.a. the era of excess ­– has just begun. Charles Ponzi wanted in on the fun and came up with an excellent idea for a business. Or so he thought...

Back then, when you sent a letter abroad, you'd often include an “international reply coupon” that could be exchanged for stamps in the recipient's country so they could reply to you. Crafty Ponzi realized that in some countries the cost of a coupon was less than the price of US stamps, so he could buy coupons in Italy, redeem them for stamps, then sell the stamps and pocket the difference.

Ponzi thought he’d struck gold. But to execute, he needed a lot of cash – cash that he didn’t have and banks wouldn’t lend to him. Undeterred, he turned to individual investors instead, promising them that he’d double their money in a jaw-dropping 90 days.

Instead of setting off alarm bells, the promise worked and money started flowing into Ponzi's operation very quickly. Within six months, $2.5 million had been invested in the scheme – that's about $30 million in today's money.

But there was a teeny-weeny problem. Though Ponzi’s scheme worked in theory, to fulfil his obligations he’d need to transport tens of thousands of coupons from Europe. Shipping was expensive and Ponzi was greedy. There was a cheaper (and fraudulent) way to deliver investors their return.

Ponzi started paying his earliest investors using money from later investors. It was effectively a never-ending chain of money – with no actual profits being made.

The scheme continued to grow: 40,000 ordinary people gave Ponzi their cash, seduced by his claims of massive returns. In the end, its popularity was its downfall. Newspapers began to investigate, and revealed that for the scheme to work legitimately, there'd need to have been 160 million coupons in circulation – in reality, there were only 27,000.

That was the beginning of the end. Investors got spooked, asked for their money back, and with Ponzi massively in debt the whole thing collapsed. All in all, around $250 million in today's cash was lost. People who invested their life savings saw their finances destroyed. Ponzi, meanwhile, was sent to jail – and ultimately died broke.

But we all learned our lesson, right? Hah. We wish. Ponzi may have been history’s most famous scammer, but he certainly wasn’t the last. The promise of massive profits is a great way to get you to let your guard down, and time after time unsavoury people have used that to prey on investors.

You might think that you're immune from falling for the murkier schemes out there. But don't be so sure. Keep reading to learn about some of the other scandals from history.

Bernie Madoff and pyramid schemes

Ponzi’s fraudulent scheme was so famous that his name became synonymous with scams. We now call any similar venture – where investors’ money is being used to pay out other investors – a Ponzi scheme. Such schemes are inherently unsustainable because no actual money is made – cash is just being shifted around until it eventually all blows up.

Has anyone else pulled a Ponzi? The biggest ever Ponzi scheme was unveiled in 2008. It involved Bernie Madoff, a (once) well-respected investor… who, prior to his death in 2021, was sentenced to 150 years in prison.

Madoff claimed to have a sophisticated investment strategy that would make investors a consistent return of 10-20% per year. In reality he was, just like Ponzi, depositing investors' money into a bank account and using later investors' cash to pay off the earlier ones. But when the downturn of 2007-2008 hit, it all went south. Investors started asking for their cash back, Madoff obviously didn’t have it all, and the scheme collapsed.

The critical difference between Ponzi and Madoff was scale. Madoff took in about $65 billion. Just to put this into perspective, that’s a bit more than Bulgaria’s GDP. He managed to dupe almost everyone, with global banks like HSBC and Santander losing more than $1 billion in the process. This shows how scary scams like this are – even sophisticated investors can fall for them.

Is a pyramid scheme the same as a Ponzi scheme? The two are similar, but there are slight differences. Both rely on a never-ending stream of new investors, but pyramid schemes get you to recruit the next batch of victims. They pay you a commission for signing new people up, incentivizing you to keep growing the pool of investors. Pyramid schemes are just as unsustainable as Ponzi schemes and are often illegal as a result.

As an aside, also keep an eye on so-called multi-level marketing companies (like Herbalife and Amway). These encourage salespeople to recruit other salespeople further down the chain, for a cut of their revenue. The difference with pyramid schemes comes from these companies’ focus on actually selling products rather than just siphoning money up the chain – but it can be a subtle difference sometimes, and some governments have banned them entirely.

So how can I protect myself? First of all, if something sounds too good to be true, it probably is. Sorry. Two things to watch for in particular are the promise of very high and very consistent returns – the likelihood of someone achieving both is very slim – and being asked to sign up other investors yourself.

You should also insist on examining financial accounts and never invest before properly understanding how a return is generated. Being told there's a “clever algorithm” isn't good enough! A secretive company is a massive red flag – be especially wary whenever anyone cites needing to protect their competitive advantage as a reason not to share information.

Checking if a company is regulated can help too. However, as Madoff proved, even seemingly legitimate companies can be dodgy under the hood.

Scams like this are particularly prevalent during a market bubble, so that’s when you should be on extra high alert. Find out more...

Crypto scams

Have there been any Ponzi schemes in the last few years? Yep! The best known is probably BitConnect, which put a crypto spin on the whole thing. BitConnect was a bitcoin lending platform where you’d deposit money that was then lent to other people, and in exchange, you’d receive a “guaranteed” return of 1% per day. For example, if you put in $1,000, you would have $1.4 million in two years. Plus, if you deposited more cash, you’d receive greater returns, and there was a multi-level marketing element that offered commission to people signing up investors to the platform.

BitConnect claimed to have sophisticated trading software that would generate these massive, consistent returns. Surprise, surprise – that seemingly didn’t exist. Authorities eventually caught on, and the platform was shut down in early 2018. Owners of BitConnect’s token – which is how returns were distributed to investors – lost a lot of money as its value crashed in the aftermath.

How about other crypto scams? The notorious Pincoin ICO was an even more brazen scam. Back when these initial coin offerings were all the rage, Pincoin offered token owners a 48% monthly return. That promise lured people in, and Pincoin managed to raise $660 million.

But then the founders of Pincoin just… disappeared. Pincoin appears to have been run by a group of Vietnamese scammers, but the Vietnamese government’s investigation into them started too late – the money was already gone.

Why has crypto seen so many scams recently? Such a market is a fantastic opportunity for scammers. Complicated technology, the allure and excitement of big returns, and a lack of regulation all make for a perfect storm of confusion – one that con artists are scarily good at exploiting.

In such scenarios, you should be even more cautious than you otherwise would be. It’s particularly scary how slow governments are at responding to the scams. It can often take months or even years for regulators to enter a market and clean it up.

Once again, alarm bells should start ringing if you are promised crazy returns. Also, try and do your research on the team behind the investment opportunity, and remember that if you’re investing abroad, you’re exposing yourself to even more risk as you have to rely on international authorities to be on top of things.

Why "regulated" doesn't mean safe

Are all regulated products safe? Not necessarily. Financial regulation is complicated, with approval given for specific activities such as offering certain products or advertising to the public. And regulators aren’t always entirely on top of things.

Some recent cases have seen firms and comparison sites marketing risky bond products as “fixed-rate accounts,” misleading investors into thinking they’re putting money away in a safe bank account. In reality, their capital was at risk.

Even when the law is followed to the letter, loopholes and legal trickery mean that things aren’t always as they seem. Some peer-to-peer lenders (platforms that let you offer loans to small businesses and individuals) and so-called innovative finance companies tend to bury information about risks on their websites. They market their returns as almost guaranteed when, in reality, you’re taking on a lot of risk.

But bank accounts are always safe, right? You’d hope so! But not necessarily. In the run-up to 2008, lots of British savers put money into Icelandic bank accounts in the pursuit of higher interest rates. When the crisis hit and those banks collapsed, their money was lost.

So how do I make sure my money’s safe? If you want to make sure your cash is as safe as it gets, the best bet is to put it into bank accounts that are guaranteed by your government. Look out for FSCS-protected accounts in the UK. While they’re unlikely to provide much of a return, the government will compensate you if the bank goes bankrupt. There is a limit on how much you’re insured for, however.

For anything else, remember that financial rewards always come with equivalent risks. If you’re offered a high return, that’s because something a bit (or potentially very) risky is being done with your cash. You might be okay with that... but you need to be aware of it. Finally, we’ll go through exactly how to gather all the info you need to make an informed decision.

How to spot a scam

How can I tell if something’s dodgy? Trusting your gut on whether something is “too good to be true” is all well and good, but sometimes even that might not be enough. Fortunately, with a little bit of research, you can get a better idea of an investment’s financial riskiness. These are some of the things to check:

🔷 Is it reputable? One of the best ways to figure out if you’re getting in bed with the wrong people is to ask others. If you want to make sure you’re safe, only trust companies that the financial press and reputable comparison sites approve of.

🔷 Who’s in charge? Look up the people behind the company. Are they experienced financial professionals or just a couple of dudes working out of their basement? It’s also worth googling the names of the company’s directors to see if they’ve been involved in any previous scams or scandals.

🔷 Is it regulated? The most disreputable financial companies won’t be regulated with the relevant authorities, meaning you should probably steer clear of them. Don’t just take a company at its word if it says it’s regulated – do your own research! Look up the company’s ID on the authority’s database to check for yourself, and make sure it’s regulated for the service it’s actually offering. For example, if the firm is selling an investment product, it should be regulated for more than just providing financial advice.

🔷 How is the return being generated? Scams will often promise massive returns but obscure how those returns are actually generated. Look past the attractive marketing claims and try to figure out where your money is actually going. If the company isn’t willing to give you that info, then think twice before giving them any of your money.

Ultimately, however, there’s no way to be completely safe. Sorry. Bernie Madoff managed to deceive almost everyone, remember. But by being on alert for the kind of scams we’ve looked at in this article and doing a bit of research, you can hopefully avoid the worst of the worst. Good luck and take care out there!