THERE are two fundamental axioms that the investing public must understand and appreciate when investing its hard-earned savings:

1. The higher the yield expected on their investments, the greater the risk.

   The risk comes in many forms. The most common risks are:

   1. Credit or default risk meaning the risk that the recipient of the investment will not be able to repay the promised or expected yield and even the principal.

   2. Term or liquidity risk meaning that given the same credit risk, longer-term investments usually yield more than shorter term.

   Price or market risk meaning that if the investment is a marketable security, its value can move up or down for the duration of the security depending upon movements in economic variables such as interest rates, economic growth or recession and developments in the company or country issuing the security.

2. Investors should check thoroughly before investing in entities or instruments being sold that promise returns substantially higher than the norm.

   This axiom follows from the first. If the promised or guaranteed returns are much higher than normal, the money would most likely be put in investments that are of very high risk and the chances of the entity and the investor losing the money will also be high. What is worse is that the scheme could be a scam and the investor is a likely victim of the scam.

Financial scams usually “promise or guarantee” very high yields or returns

Based on the premise that the higher the yield the higher the risk, the investing public should be wary of guaranteed returns that are inordinately higher than what is available in the market. The operative term is “promise” or “guarantee.” Legitimate issuers or sellers of investment instruments may sometimes show investment instruments that have the potential to give a high yield or return, but the investor is also duly informed that there is no guarantee on the return and oftentimes even on the recovery of the principal. These instruments and their sellers would have to be duly authorized by the Securities and Exchange Commission, and in case of banks, also by the Bangko Sentral ng Pilipinas. It is always prudent for the investor to see certification from the proper authorities before parting with their money.

Ponzi Scams

When we read or hear about financial scams we often hear of it being referred to as a Ponzi scheme. This term refers to the notorious Charles Ponzi, who committed the biggest investor fraud in the United States in the early 1920s. Ponzi enticed investors to invest their money with him by promising very high returns, which were paid from the proceeds of new investments. In the process, Ponzi pocketed a lot of the investors’ money himself. Obviously, the investors’ funds were not used to generate earnings and value to economically service the promised return on investment and even to return the principal. It was only the inflow of more investments seeking very high returns that were used to pay the returns and principal of the earlier investors. And when the inflow of new investments slowed down and stopped, the bubble burst and the investors ended up holding the empty bag.

Financial scams generally follow the pattern of a “Ponzi” scam of promising very high returns and using the funds coming from new investors to service the returns on existing investors until the inflows can no longer keep up with the outflows and then the bubble bursts. Other terms used to describe financial scams are, “pyramiding,” “kiting” and “borrowing from “Peter to pay Paul.”

It must also be borne in mind that the financial scam artist or artists can be very sophisticated. Inevitably the scam perpetrated by Bernard L. Madoff must be mentioned in this subject matter. Madoff was a former chairman of the NASDAQ stock exchange in New York. He fooled rich individuals and even institutional investors who lost about billion by investing in his funds. His scam was discovered during the credit crisis of 2008, shortly after the collapse of the Lehman Brothers Investment Bank. It may be no coincidence that the scam was discovered at this time. Investors around the world including the clients of Madoff were withdrawing their funds out of need or fear of greater losses and hence Madoff could no longer continue with his “kiting” or “pyramiding” operation.

Analyzing high yield guarantees on investments

There are a few basic guides that should be useful as prudential guides before investing in high-yield instruments or schemes. First is to ask and find out where your funds will be invested in. Next is to ask and verify the certification or authority of the person or institution soliciting the investment. The investment instrument should also be properly registered or authorized for issuance and for selling. The investor must also do some analysis of the instrument compared to other investment instruments available in the market.

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* Written by PDIC President Valentin A. Araneta for Free Enterprise and published in the Businessmirror on April 26, 2011. Mr. Araneta writes for the Free Enterprise column as a member and officer of the Financial Executives of the Philippines (Finex). Requests for his past articles may be coursed through ccd@pdic.gov.ph.