20% of nothing is still nothing - What does this mean for your finances?
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By Pierre Muller
Just pause to consider the following headline run in the venerable Financial Times in November 2020: “Investors lose £657 million to fraud.” That’s just in the 12 months to September 2020, up 28% from the year before. Even before the full impact of Covid-19 was felt on the global economy, CNBC reported that in 2019, authorities in the United States had uncovered 60 alleged Ponzi schemes. In total, this equated to $3.25 billion in investor funds.
Quoting from the Ponzitracker website, CNBC went on to say that this figure was more than double that recorded in 2018, and the highest since 2010. All eyes will now be on the complete 2020 figures as they emerge, given the implications of coronavirus for economies merged with the constant search for yield in a low-growth environment.
History, of course, tells us that Ponzi schemes and financial scams are nothing new. However, their sophistication in the online space and in a digitally connected world are tailor-made for casting a wider, global net that lures potential investors with promises of 20% or 30% returns – or, in one recent incident, interest of 7% a week.
A LITANY OF WARNING BELLS
Schemes designed to part you and your hard-earned capital have a long and notorious history, perhaps most famously with Charles Ponzi’s original 1920s creation. More recently, in South Africa, we saw the 2007 Fidentia investment scam which resulted in mastermind J Arthur Brown being sentenced to 15 years in prison for fraud in 2014. Both Ponzi and Brown duped investors with guarantees of meteorically high yields.
As history tells us, of course, these expectations often come with a catch. This underlines the importance of knowing how to distinguish between a scam and a sound investment option that delivers solid returns.
Right now, during this uncertain time in world history, many clients, businesses and governments are experiencing financial pressures brought about by the economic impacts of the Covid-19 pandemic and the associated lockdowns. Faced with this uncertainty, and record-low interests rates in markets such as South Africa, Japan, Switzerland and the European Union, the temptation to seek out attractive returns is compelling.
PROTECT YOURSELF AND YOUR WEALTH
When faced with investment decisions that “look too good to be true”, it is critical to remember that there are only a finite number of instruments which you can invest in with the aim of earning an income. While products may change and receive a facelift over time, the underlying fundamental asset classes in which you invest – and which drive your returns – do not change.
The first trap to avoid are financial institutions which do not disclose returns clearly and in a way which is easy to understand. For example, in recent years, some conservative cash investments were promoted to provide a 13%* return. Note the * - that’s where the fine print is hidden. This conservative investment would then be perceived to generate an annual return of 13%, which sounds wonderful, but just isn’t true.
The fine print read something like: If you hold this investment for five years, then your return over the five-year period will equate to an average of 13%. This is due to compound interest. If you hold an investment with an annual return of 9% for a period of five years, the annual interest-on-interest compounding effect will result in an average return over the five-year period of 13%. It would, therefore, be incorrect to compare this 13% to the annual returns of other investments and assume 13% is better. The real annual return is 9%, which is the number to compare.
The next stumbling block is guaranteed high returns. If someone offers you a guaranteed return of 20% or even 30% and more, but you know that realistically they will only be able to earn a 13% annual return based on the historical return of the stated asset class (more on that 13% later), then it should be fairly clear that the methods being used to make up that substantial 17% gap are likely to be unsavoury and risky.
Some legitimate products will aim to make up for this gap by using derivates and gearing within the solution. The result is a large increase in the risk associated with this investment. This risk should be explained and disclosed very clearly by the product providers to investors, so that they understand the potential downside. For example, the return on investment might be 30% if the planets align, but if they don’t the result could be -50%.
Then, of course, there are scams which take us beyond risky investments into the realm of fraud. While scams come in various forms, they frequently make up the 17% shortfall mentioned above by giving you someone else’s money. For example: Mrs First Victim invests R100 with her “investment advisor”, Mr Ponzi. Mr Ponzi promises returns of 30% a year. In order to achieve just a 13% return (R13 in this case) in the stated asset class, Mr Ponzi will need to invest that money for a long-term period. Now Mr Ponzi needs to find R17 to give Mrs First Victim her promised 30% return – otherwise, the scam falls flat from the start.
Enter Mr Second Victim, who also wants to take advantage of this wonderful opportunity. Mr Ponzi takes the R17 he needs from Mr Second Victim’s R100 and gives it to Mrs First Victim. Now she is happy with her 30% return and tells all her friends, and Mr Second Victim looks forward to his amazing returns.
Mr Ponzi’s new problem is that he has only R83 left of Mr Second Victim’s initial R100 investment from which he needs to generate R30 (30% of R100). He invests the R83 and earns a 13% return, which gives R11 return.
Mr Ponzi must now find another R19 (R30 – R11) to make up the difference, which he gets from Ms Third Victim’s R100 investment. And so the cycle continues, and Mr Ponzi’s problems escalate. The moment new inflows don’t meet Mr Ponzi’s distribution needs (either because regulators have intervened or investors get suspicious), the whole house of cards comes crashing down.
But why is it not possible for Mr Ponzi to legitimately invest your money and generate a 30% return per year?
A WORD ON RISK
Well, as indicated previously, there are a finite number of asset classes in which you can invest to achieve a return on your money. These range from conservative cash investments in a bank to shares. Every asset class has a risk/return profile. If you want a low-risk investment, you must accept a low return.
If, on the other hand, you are willing to take on more risk and invest in the stock market, for example, then you should get a higher rate of return, but you will experience more volatility during the process and will likely need to commit your capital for a seven-year period or longer in order to realise those returns. Then, between the extremes of low-risk cash and high-risk equities lies the asset classes of bonds, property, hedge funds and the like.
A direct offshore stock market investment, which is on the risky side of the spectrum, has provided an average return of 13% over the long term. Of course, there will be years of 20% returns or more, and also years of significantly negative returns such as those experienced during the 2008/2009 financial crisis and the first half of 2020 due to the Covid-19 impact. No one knows for certain which shares within the stock market are going to generate the best returns. The safest way to ensure your money generates a return above inflation is to diversify your risk and hold shares in different companies, in different sectors, in different countries and even in different currencies.
Getting the mix right between asset classes and ensuring that you have a nuanced understanding of the inner workings of options within such assets takes skill and deep investment knowledge. This is where professional financial advisors step in. Someone in a nifty suit with a financial background, say in tax or property, is not necessarily qualified to give the sort of sage investment advice you need to navigate the complex world of investing. Only engage with a financial advisor who is a registered representative of an authorised Financial Services Provider company and is authorised to give financial advice. If a person does not meet these criteria, then walk away.
Ultimately, as an astute investor you know that investment fundamentals don’t change overnight. You know that investing is not a sprint but a marathon – a journey that takes careful planning, precision and dedication to the end goal. History also tells us that the best way to reach your financial goals remains the same: start saving and investing at an early age, work with a qualified financial advisor who can offer guidance along the way and you will reap the benefits over time.
Anything else is just pie in the sky.
Pierre Muller is an Advisory Partner at Citadel