Sunday, August 26, 2007

Get rich quick! Guaranteed!

THERE IS NO SUCH THING as a risk-free investment, but there a many who promise fantastic returns on supposedly risk-free terms. Fools believe them, and fools and their money are soon parted.

How does a pyramid scheme manage to entice so many otherwise prudent people to invest?
First, there’s the hook. Extraordinary Returns. Celebrity Investors. The earliest participants always make money as it is their word of mouth that attracts the gullible into supporting the scheme.

Pyramid schemes work by paying out the fantastic returns to early investors from "investments" made by downstream investors. Sooner or later, as the pyramid grows, there will no longer be enough "new investors" to support the ever widening base, and the pyramid collapses.

The proponents and the upline disappear, all feigning ignorance of the scheme, while the last in always, and inevitably, lose their money.

The Securities and Exchange Commission differentiates between pyramid investment schemes and multilevel marketing enterprises in the following way:

If most of the commissions are earned by recruiting new investors, salespersons, or clients, then it is an illegal pyramid. If, however, the commissions are derived from the sales of genuine products, then it is a possibly legitimate multilevel marketing business.

This is where the line is drawn: Commissions from recruitment = Illegal pyramid, commissions from product sales = possibly legitimate multi-level marketing business.

Tupperware, Sara Lee, and Natasha are examples of multi-level marketing programs. Many people make good income from legitimate MLMs, but it requires extreme determination and unique personality skills, so they’re not for everyone.

Pyramid schemes claim legitimacy by saying the money will be used for "telecommunications," "pawnshop lending," "gold investment," etc.

Think about your own business experience: Can any business that obtains funds at more than 100% per annum possibly be viable? Yet, these pyramid schemes promise guaranteed returns of up to 4.5% per day! The only guarantee is that you’ll never see your money again.

Another scam is foreign exchange trading.

Only large banks trade in large foreign exchange transactions and with good reason: Each transaction is in the millions of dollars, and the movement is in the tenths of a percent. On a million dollars, they will make or lose ten dollars. This is not a market where retail investors can effectively participate in.

The only relevance of foreign exchange movements to retail investors is in determining how to balance your assets: How much should I keep in peso assets? How much should I keep in dollar assets? How much should I keep in euro assets?

"Forex Shops," claim to provide leverage of up to 98%, explaining that a 2% movement allows you to double your money. They’re not so enthusiastic about explaining that it also means that a 2% movement THE WRONG WAY means you’ll lose ALL YOUR MONEY.

The Forex houses know this, that’s why many are not even real traders at all.

They’re bucket shops, pooling all the investors funds in a "bucket," paying out the winning trades, but profitting from the high probability that most trades will lose money. When currencies move strongly in one direction and their clients make paper profits by being on the right side, they simply close down, taking the bucket with them.

Our Securities and Exchange Commission has good material on avoiding investment scams here and here. Yet, with bank interest rates at all time lows, are there reasonably safe and legitimate means to make money?

First, extinguish the notion that there is such a thing as a risk free investment.

US treasury bills and bonds, considered the gold standard of low-risk investments carry foreign exchange risk: Just ask anyone who purchased dollar assets in 2005: They’re now down around 20% visa-vis the peso (Asia’s best performing currency over the last two years), and around the same amount vis-a-vis the Euro.

With interest rates in the low single digits, there’s also the opportunity cost. And unless you’ve purchased your bills through a legitimate banking channels, there’s also the risk that what you’re holding might be fake.

Peso treasury bills offer slightly higher rates, and the retail treasury bill market offers a safe way to participate. Want more? Then you’ll need to accept risk.

Refusing to accept risk is why many people fall for these scams: they’re dissatisfied with the low interest rates of legitimate instruments, so they’re willing to hand over their money to anyone making unrealistic promises of "risk-free" investments.

Promises are made to be broken. Unrealistic promises aren’t worth the saliva they’re said with.
Philippine T-Bill rates hover around 5% annum. These are the lowest risk investments available. Anything higher than that involves higher risk.

Incredibly high returns of 4.5% per day have infinite risk because they’re so obviously scams.
That doesn’t mean that one should not seek out higher returns. The stockmarket, the real estate market, and investing in businesses, have provided higher returns over the past five years.
Stocks and real estate are asset classes that exhibit cyclical behavior.

There are times when people think the world is about to end, and they can purchased cheap. There are times when people are willing to pay ridiculous prices for stocks and real estate.
Anyone who purchased PLDT shares in 2002 would have made twelve times their money.

Meralco shares are up seven-fold.

Real estate investments in small condominiums would have provided healthy rental revenues from call center employees looking for affordable digs near their places of work. Real estate investments in vibrant secondary cities outside Metro Manila would also have provided stellar returns.

Fortunately, we’re still somewhere midway through the current upcycle, last week’s price declines notwithstanding. We’re definitely not at the beginning of another "Asian Crisis," as this time the money is here in Asia, not running off to the United States to feed a dot-com bubble.

Both real estate and stocks still have some upside. The stockmarket’s "Price to Earnings Ratio" is still roughly half what it was at its peak in 1995, and real estate in areas where new infrastructure has been built (i.e. Along the MRT lines and along new highways) has good upside.

At HSBC’s Young Entrepreneur Awards last month, each of seven countries presented their winning business plans. I couldn’t help but think that of all the teams, Hong Kong’s had the best chance of obtaining funding for their proposals and transforming them into viable businesses.
That’s the nature of successful economies like Hong Kong’s. They understand risk, so are willing to invest money in promising businesses.

So, even if Bangladesh won over-all, and the Philippines won best presentation, it’s unlikely that their ideas will ever go beyond the paper stage for lack of funding. We deny capital to honest entrepreneurs, yet willingly hand over money to whoever shady character promises dubious risk-free investments.

Recognizing and managing risk is the key to above average returns. Risk exists everywhere: Get over it. Once you’ve done that, then you can make informed decisions about where to put your money.

Not everyone needs to become a risk management expert to invest wisely. Universal banks offer Investment trusts that specialize in particular asset classes: Fixed income instruments, Corporate debt, Listed equities, and soon, Real Estate Investment Trusts. The experts at established banks are well-trained to do the asset selection for you and their private bankers can help you determine the optimum balance of asset classes based on your needs.

For anyone below thirty years old, a whole life investment policy, one that pays you a lump sum at the end of a number of years, is also a sound investment. That lump sum can be used as downpayment for a real estate purchase later on.

Directly investing in a business is also another option. There are hundreds of entrepreneurs with bright ideas looking for funding. Your friends might be planning a business. Seek them out, meet with them, try to understand their business plans, and use your own experience to evaluate their business risk. If it’s acceptable to you, then consider investing in exchange for equity.

Just be realistic. Some businesses succeed, but many fail.

Out of every five investments, two will go sour, two will muddle through, and one will succeed beyond everyone’s wildest dreams.

Even businesses that fail have some value: They may have assembled a good team that could be effective working on some other idea, or that entrepreneur you’ve helped may move on to bigger things and offer you more favorable terms.

Diversification is another key to obtaining higher returns. Don’t place all your eggs in one asset class. Invest a little in promising startups, buy a small piece of real estate, place some money in stocks, either directly, or through a managed investment trust, but keep a little in low risk treasury bills or time deposits with a reputable bank.

Just remember: There is no such thing as a risk -free investment, and anything that promises a return higher than 5% annum has higher risk, but because risk can be managed, it’s possible to obtain higher returns from your money. Just don’t be stupid and fall for obviously fradulent schemes.

If, however, you’d still like to put your money into one of those "get rich quick" guaranteed scheme, drop me a note, I’d like to talk to you about a bridge I’m selling...