There have been many scams recently where high investment returns of 20% to 30% per year are promised to investors.
With consumers feeling the pinch of the current, challenging economic environment, the promise of such lucrative returns is most appealing.
But how do we distinguish between sound investment options with solid returns and scams?
The key point to note is that there are only a finite number of instruments in which you can invest your money in order to earn 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 return – don’t change.
So if someone offers you a guaranteed 20% to 30% return, but you know that realistically they will only be able to earn a 13% return (see below) given current asset-class performance, you know they must have a questionable method of making up the difference of 17%.
While scams come in various forms, they often make up the 17% shortfall by giving you someone else’s money. For example: Mrs First Victim invests R100 with her “investment advisor”, Mr Ponzi.
Mr Ponzi promises her 30% returns per 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 in order to give to Mrs First Victim the promised 30% return, otherwise the scam falls flat from the outset. 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 problem now is that he only has R83 left of Mr Second Victim’s initial R100 investment from which he needs to generate R30. He invests the R83 and earns a 13% return, which gives a R11 return.
So Mr Ponzi must now find another R19 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 intervened, investors got suspicious or no “greater fool” can be found) the whole house of cards comes crashing down.
So, why is it not possible for Mr Ponzi to legitimately invest your money and generate a 30% return per year?
As previously mentioned, there is a finite number of asset classes in which you can invest to give you a return on your money. These range from conservative cash investments in a bank to shares on the JSE. 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, you will 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 more to realise those returns as a result.
In between the extremes of low-risk cash and high-risk equities lie the asset classes of bonds, property, hedge funds and the like.
A direct stock market investment, which is on the risky side of the spectrum, has provided an average return of 13% over the past 100 years. There will be years of 20% returns or more, and years of significant negative returns such as those experienced during the 2008/9 financial crisis.
No one knows for certain what shares within the stock market are going to generate the best returns, and 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.
Someone wearing a suit with a financial background (i.e. in tax or property) is not necessarily qualified to give investment advice.
Only engage with a financial advisor who is a registered representative of an authorised Financial Service Provider company and who is authorised to give financial advice. If a person does not meet these criteria, walk away.
While we may yearn for a 30% return on our money, the old adage, “If it sounds too good to be true, it probably is,” springs to mind. Investment fundamentals don’t change overnight. And investing is not a one-day game.
Start saving and investing at an early age with the advice of a qualified financial advisor to guide you and you will reap the benefits over time and reach your financial goals.
* Pierre Muller is an advisory partner at Citadel.