Over the last two months we have looked at a few past and present investment schemes that have one major thing in common - they all failed leaving investors significantly out of pocket.
Naturally some investment schemes work, the projects are profitable and everyone gets the returns that they expected. So what distinguishes schemes that fail from their successful cousins?
We have identified seven common factors. Not all failed schemes will have all seven factors, and even some successful schemes will have one or two of them. This is not a case where there is an absolute right or wrong, but the more of these factors present in the scheme, we believe the more prone it is to fail.
1. Offering High Returns. Some investors fail to acknowledge that a promised high return almost always means a high risk investment, and risky investments by definition have a higher likelihood of failing. If the risk was low, main stream financiers would be willing to invest and the return would be driven down by market forces. Offering high returns is done to convince people to take that risk.
2. Large Numbers of Smaller Investors. Usually numerous investors will each only put in a small portion of the entire capital invested - albeit that individually it may be the investor's life savings. There is no significant investor who could exercise some control due to the size of their investment. Investors generally have some commonality, whether they are clients of financial planners or solicitors, or are from a common social community. A number of them will be elderly and liquid from retirement or superannuation funds, but with little experience in investing.
3. Gullibility. The investors are not usually connected to the industry in which the scheme will invest, so they cannot critically assess the investment's potential themselves. They have to rely on the advice of other people, who generally are the promoters who want them to invest. They do not get proper independent advice. They want to believe what they are told and invest based on that recommendation.
4. The Project is not Viable. If the project's profitability was assured there would be little risk, commercial rates of return, and main stream money invested. The failed schemes had projects with very little chance of making the promised returns. Valuations and development plans were usually prepared on unrealistic assumptions, were obtained by the borrowers, and used to recruit investors without significant verification.
5. Legislative Blank Spots. Many failed schemes took advantage of some regulatory or legislative blank spot. There was little legislation covering investments and companies in 1720. Westpoint skirted parts of the Corporations Acts by using promissory notes instead of securities, and the old solicitor's mortgage schemes had very little regulation. These blank spots allowed the schemes to be promoted without the detailed prospectuses or other information being made available and without independent reviews.
6. The Appearance of Respectability. Promoters try to get some air of respectability from either a prominent person or organization, or from a connection to the potential investor. The SSC had Royal approval and many prominent members of society as shareholders. The solicitor's mortgage schemes were run by investor's solicitors - respectable business people trusted by their clients. Westpoint utilized financial advisors that were trusted by their clients. These connections create an image of professionalism and build trust in potential investors.
7. A Disregard for Investor's funds. There was generally no obvious intention to defraud the investors. The schemes were not set up as Ponzi Schemes. But there does appear to have been a reckless disregard for the investor's funds. Most promoters received a financial benefit as up front fees regardless of whether the investments failed or succeeded, and high commissions were paid to middlemen to obtain the funds. The money invested was not treated with the care that one should expect.
Who is to blame for the investor's losses?
The Free Market Economy says that high returns equal high risk. People investing in high risk investments have to expect some failures and losses of capital. They can also expect high returns when the investment works.
Regulators try to protect naive investors who want to make high returns with little work or knowledge. Legislative blank spots allow some high risk investments to be promoted without adequate information. But governments should not restrict people from making risky investments if they decide to do so. It should only ensure that adequate information is available.
Ultimately investors cannot be protected from their own stupidity and gullibility, or greed and ignorance. Some people want to believe that they can easily make lots of money and will become convinced of whatever they are told. Regardless of warnings and with all the information that could be made available, some people will invest in anything promising a high return.