How to spot a 'ponzi' scheme

Recently, there were reports that the West Bengal Government is considering to pass a law against Ponzi Schemes. The law, if passed, would allow police to take action against the perpetrators even without waiting for some victim to complaint. So far, action can be taken only after someone complains. By that time, it is already too late. Whereas the perpetrator may get punished, but the victims do not get their money back. Some of the state governments already have the requisite laws in place.

What is a Ponzi scheme?

SEBI's website gives a nice definition of a Ponzi scheme. The same is reproduced as under:

"A classic con trick that has been repeated many times both before and since Charles (Carlo) Ponzi gave it its name in the 1920s. The scheme begins with a crook setting up as a deposit taking institution. The crook invites the public to place deposits with the institution, and offers them a generous rate of interest. The interest is then paid out of new depositor's money, and the crook lives well off the old deposits. The whole scheme collapses when there are not enough new deposits coming in to cover the interest payment due on the old ones. By that time the modern day Ponzi hopes to be living under an alias in a hot country with few extradition laws."

As is clear from the above, someone comes up with a nice "mouth-watering" proposition to take away money from the gullible. There have been various schemes floating around in the market at different times, e.g. we had plantation schemes in the 1990's, or NBFC deposits around the same time, more recently, there have been certain limousine companies and there was a news item of someone offering to double the money in 45 days.

So whenever there are such offers coming our way, what should one be looking for? What is the best protection for investors? Are the regulations enough to take care of safety of money? Well, taking an analogy from a more familiar place, the traffic police system has been around for decades, but road accidents do take place. It is the road traveller's responsibility to follow traffic rules, wear seat-belt or helmet (as applicable), etc. Similarly, in the world of investments, it is the investor's duty to take certain safety precautions. At the same time, the role of regulators is important in setting the framework in which the markets operate, but then again, there are drivers on the road that violate traffic signals and speed limits.

What should one be looking for?

The first and most important question should be, "Does economics explain the performance of the investment option?" Let us look at the definition of investment. In his classic "Security Analysis" the father of investing, Benjamin Graham, defines investment.

"An investment option is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

The return can come from

• Either future income, or
• Storage of value (not the principal value but the purchasing power), or
• Capital appreciation at a later stage

As Jason Zweig added in his commentary in the 2003 edition of Ben Graham's book "The Intelligent Investor":

"Note that investing, according to Graham, consists equally of three elements:

• You must thoroughly analyse a company, and the soundness of its underlying businesses, before you buy its stock;
• You must deliberately protect yourself against serious losses;
• You must aspire to 'adequate', not extraordinary, performance."

While Jason Zweig talks about stock investing, the principles are applicable to any investment option. We may read the first element as "you must thoroughly analyse the fundamentals of an investment option before buying it."

In order to analyse the fundamentals of an investment option, some of the things become essential:

• Whether the investment avenue is covered by any regulation, and
• The level of disclosures

Going back to the road travel analogy, travelling on road is safer largely due to the traffic rules - the regulations. (Of course, one must also give due credit to the vehicle designs and the skills of the drivers. But both the latter may be insufficient without proper traffic rules.)

Thus, the first check for any investment should be whether the same is covered under a regulation. The plantation schemes did not have any regulator, nor did the limousine schemes. After ensuring the presence of regulations, one must see how stringent the regulations are. Relaxed regulations allow enough loopholes for the perpetrators to exploit.

The second check one must perform is to see the level of disclosures. Disclosures do not mean track record. The disclosures should be able to explain how the investment avenue can generate the promised (or even indicated or projected, to use some mild terms) future performance. If one is unable to find that out, one may be better off letting go of an option than to walk into a blind alley. As Graham defines investment, the third element suggests that an investor must aspire to adequate and not extraordinary performance. Letting go of an extraordinary opportunity - a multibagger - thus is a natural thing for an investor if the investor does not understand the option.

Considering the above, a well-diversified mutual fund perfectly fits into the definition of an investment. The salient features of such an investment vehicle are:

• Well diversified investment portfolio: Diversification reduces the overall risk of the portfolio
• Regulation: Mutual funds in India are highly regulated. I do not mind to stick my neck out and announce that mutual fund industry is among the most stringently regulated industry in the entire economy. It is in the interest of the investor that the level of regulation is so high.
• Level of disclosures: Once again, this industry scores over almost anything in the country with regard to the level of disclosures. It is not difficult to understand what can be expected from investing in mutual funds and why.
• There are no guaranteed returns: The regulation does not allow mutual funds to guarantee returns. This sometimes works against the mutual funds, but a mature investor should consider this as an advantage. Guarantees generally fail to work if they are not of very low returns.
• Risk passed on to the investor: This is another mutual fund advantage to safeguard investor interest. The investor can carefully assess the risk that one is exposed to. In most other cases, it is almost impossible for lay investors to assess the level of risk and then eventually rushing for high returns, one loses the entire capital.

Thus, any investor who does not have the time and inclination for researching various investment options must invest their money through mutual funds only.

At the same time, we would like to mention that such benefits offered by mutual funds are not sufficient in themselves. The investor also should wear the seat-belt in a car or helmet while riding on a two wheeler. No amount of traffic rules can prevent a fatal accident. Mutual funds offer us the opportunity to do a careful analysis - it is our duty, then, to do so. (The safety mechanisms have been covered in some of our earlier articles). It will also help to go through a certified investment advisor.

Wish you all a Merry Christmas and a Prosperous 2010!

- Amit Trivedi

The author is proprietor of Karmayog Knowledge Academy. He can be reached at karmayog.knowledge@gmail.com

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