Beware of investment scams: Lessons from recent frauds

Soumya recently visited a branch of a public sector bank to renew her fixed deposit (FD), which had been active for five years. During her visit, a bank executive persuaded her to invest in a Unit Linked Insurance Plan (ULIP), claiming it offered higher returns than her FD. The executive assured her that investing Rs 1 lakh annually for five years would yield significant profits. This occurred at a time when investors were flocking to the stock market following the COVID-19 pandemic. Many were enticed by the possibility of earning 20–30% returns in mutual funds. Exploiting this trend, some bank employees and agents began misrepresenting ULIPs as mutual funds to lure unsuspecting customers.

Misrepresentation of insurance policies by bank employees is a growing issue, particularly in private banks, where employees are pressured to meet strict sales targets. This practice, known as "mis selling," involves coercing customers into purchasing products they do not need, often with exaggerated promises of returns. Mis selling, alongside outright fraud, constitutes the two primary crimes in the world of investment.

A High-Profile Cyber Fraud Case

A recent example of fraud involved a retired Kerala High Court judge, Sasidharan Nambiar, who lost ₹90 lakh to a cyber scam. The fraudsters promised an 850% profit through online stock market trading. Nambiar joined a WhatsApp group named "Aditya Birla Equity Learning" and transferred money through links shared in the group. Between December 4 and December 30, 2024, the fraudsters siphoned off the funds. When neither the promised profits nor the principal amount was returned, Nambiar filed a police complaint.

This case highlights the increasing sophistication of cyber fraud. Fraudsters continually adopt new disguises to deceive their victims. Yet, traditional investment frauds, such as Ponzi schemes, remain equally prevalent.

The Torres Jewellery Scam: An Old-Fashioned Fraud

While cybercriminals employ advanced tactics, scams like the Taurus Jewellery fraud remind us that traditional schemes are still effective. This scam, a mix of a Ponzi scheme and multi-level marketing (MLM), targeted over 1.25 lakh investors, many of whom were highly educated. Taurus Jewellery, a company with six showrooms in Maharashtra, promised weekly returns of 3–7% and annual returns of up to 520%.

Initially, the company delivered the promised returns, encouraging investors to reinvest their earnings. However, when interest payments abruptly stopped, panic ensued. The company initially blamed technical issues but later shut down completely, leaving investors with losses exceeding ₹1,000 crore.

Understanding Ponzi Schemes

The term "Ponzi scheme" originates from Charles Ponzi, who defrauded investors in Boston in 1919 by promising to double their investments within 90 days. Although similar scams predated Ponzi, his scheme popularized the term. The essence of a Ponzi scheme lies in using funds from new investors to pay returns to earlier ones, creating an illusion of profitability.

Why Do People Fall for Scams?

Despite widespread awareness of such frauds, many people continue to fall victim to them. The reasons often boil down to two fundamental human emotions: greed and envy.

1. Greed

The desire to amass wealth quickly blinds investors to the risks involved. Promises of astronomical returns—sometimes as high as 500% or 1,000%—are too tempting for many to resist. This greed often overrides rational thinking, leading people to invest in schemes they barely understand. Many lack the patience to grow their wealth gradually through legitimate, long-term investments.

2. Envy

As noted by Robert Z. Alibar and Charles Kindleberger in Manias, Panics, and Crashes: “Nothing disturbs one’s well-being and judgment as much as seeing a friend grow rich—unless it is seeing a non-friend grow richer.” Envy drives individuals to pursue high-risk investments to match or surpass the success of their peers. Social media amplifies this phenomenon, spreading stories of people who seemingly achieved quick riches through risky ventures.

The Role of Social Media and Fraudsters

Social media has become a fertile ground for financial fraudsters, who promote unsuitable investment schemes to a wide audience. These schemes often target middle-class individuals, exploiting their aspirations for financial security and upward mobility.

Misunderstanding Risk and Return

A common misconception in investing is the phrase “more risk for more gains.” While it is true that higher returns often come with higher risks, this does not imply investing in fraudulent schemes for quick profits. The phrase refers to the inherent volatility of legitimate investments, such as stocks and mutual funds.

Unfortunately, many people equate mutual fund investments with fixed deposits or believe that stock trading is synonymous with speculative activities like day trading and derivatives. This misunderstanding leads them to ignore warnings, such as SEBI’s caution that 91% of derivative traders incur losses.

The Cycle of Repeated Mistakes

History has shown that financial disasters are quickly forgotten. As John Galbraith wrote in A Short History of Financial Euphoria: “Financial disasters fade from memory quickly. When similar circumstances arise, often within a few years, they are hailed by a confident, often youthful generation as groundbreaking innovations in finance and economics.” This short-term memory loss results in repeated mistakes, as people fall for the same traps under new guises.

Lessons for Investors

To avoid falling victim to investment scams, it is crucial to:

1. Understand the Investment: Never invest in a product you do not fully understand. Conduct thorough research and seek professional advice if needed.
2. Beware of Unrealistic Promises: Be sceptical of any scheme promising extraordinarily high returns with little or no risk.
3. Verify Credibility: Check the credentials of the entity or individual offering the investment. Look for regulatory approvals and reviews.
4. Avoid Emotional Decisions: Do not let greed or envy drive your investment choices. Stick to a well-thought-out financial plan.
5. Stay Informed: Keep yourself updated on the latest financial scams and warnings from regulatory bodies like SEBI.

Investment scams, whether traditional Ponzi schemes or modern cyber frauds, prey on human vulnerabilities such as greed and envy. By understanding the tactics used by fraudsters and adopting a cautious approach, investors can safeguard their hard-earned money. Remember, sound investments require time, patience, and knowledge. Always seek expert advice before making financial decisions, and invest only in what you understand.