(For general public reading, I will not use technical financial terms. I shall explain it in generic language so the explanation may be too simplistic to explain the complicated model.)
For my friends and family whom I care so much...
There is a kind of scheme with a very noble idea. A group of people pool their funds together and any member who needs the fund borrow from it. The borrower repay the loan with interest, and the members who lend get the interest. What is very attractive is the fund offers 20% interest rate return.
To ensure all members behave well and to safeguard the fund, there is a moderator who is very responsible and reliable. There is no documents, no regulations, no black-and-white in all transactions, because everything is done on "Trust". A very noble idea and a very wonderful way to help people and get help from others. In chinese language, it is called "作伙"
For friends who are considering to join a money scheme/ "mutual help fund pooling", think twice, or more than that.
- Do you know who is borrowing the money?
- Do you know who is contributing money?
- Do you know what business the borrower is doing?
- Do you know how the business is generating money?
- Do you know how the money cashflow is moving about?
- How the money is coming into the fund and how they are going out? Do the cash inflows and outflows balance? If not, who compensate for the difference?
Think about how much you can trust.- We can argue that everything is based on "Trust", and leave the fund management to a person who is "trustable", without proper license or any regulations controlling him.
- But who are these people that you trust? And who are they trusting, is it beyond your control?
- Can you trust so many strangers? I can trust my family, and the good friend I know, but do I trust the friend of the friend (of the friend...etc) that my friend trust?
Think about how workable and feasible is this scheme- You are promised 20% interest payback.
- We must bear in mind that money will not appear from nowhere, so this 20% interest must come from somebody else money.
- So where does that money come from? From the person who borrow the money from the fund, rite?
- Think from the perspective of that person, if you are the borrower, would you want to borrow at 20% interest? or you would rather borrow from your own family, friends or even the bank which offer loan at <10%?
- So will you actually borrow from the fund? If you think you won't, do you think others will want to do that?
- If nobody borrow, where does your 20% interest come from? From new people who join the fund - let's use the new fund to pay the old member's profit. How long can this chain go on before it collapse?
Ok, let's assume there is really somebody who need the money so much that he is willing to borrow at 20% interest. He borrowed the money, do his whatever business.
Here are three scenarios:
1) His business is bad. He loses money, and face difficulty to repay the loan.- If he can't repay the loan, where does your 20% interest come from?
- To sustain your return, the fund must get more new people to join, so that the new money can be used to pay your interest.
- So now who pay the new people's interest? Do we hope that more people will take up loan, and hopefully (still) their business is good and they repay the loan? or do we hope more people will join so that our money can be repaid?
- Do we have too many hopes? Do we just pass on our problem to "other people" and hope we are the earlier ones and lucky ones?
2) His business is ok. it is generating income, but he still faces many start-up costs and cannot repay in time.- If he temporarily can't repay the loan, you have to wait longer to get your interest. But how long can you wait?
- What if you need the money now? Who pay for your money?
- Again, since no money is coming into the fund, but money needs to go out to pay you. So, it needs more new people to join and sustain the fund.
- How long can this go on? What if everyone demands to get their money back now, where does the money come from to pay all the 20% interest + capital amount?
3) His business is successful. He earn large profits. He repays his loan promptly as promised.- So now everyone is happy. The borrower earns profit and is so good-hearted to pay back high interest loan. Perhaps next time he would look for proper loan with lower interest from the banks, since his business is successful now.
- The investors are happy too, we all get our 20% interest and we have helped people. Hurray.
- But if this really works, don't you think ALL the financial transactions nowadays will be at this interest rate?
- Don't you think this method will be so popular that everyone will follow, and everyone trust everyone? Everything based on promise and trust?
- Lovely ideal world. It would be so wonderful if the real world is like that.
Think about the amount of risk you are taking by trusting so many people.- All it takes is a SINGLE person who cheats, or fails his obligation --> and everything falls apart.
- All it takes is a simultaneous withrawal of all the members --> and the fund will collapse.
- All it takes is a HIGH investment return (20%) --> to make our hearts tempted by greed, and believe as a small investor, we can earn 20% compared to the most successful investor in the world who earn <10%>
- All it takes is a promise of TRUST --> to convince ourselves the world is perfect and the person whom the person we trust, is trustable.
- All it takes is a hope that other people will pay for our profits --> to make us hopeful that we are the lucky ones and it is others who get cheated.
Think about how realistic the deal is- When a good deal seems too good to be true and interestingly not many people in the market is doing it to profit, think again.
- Everything comes with a price. Money does not grow out of nowhere.
There are still A LOT of aspects to think about, which I leave you to think and explore. Explore the scheme from the perspective of all different people - the investors, the borrowers, the moderator. Is it workable?
Actually, there has been a lot of research and studies done about such scams, and all world's financial regulations forbid such practice because it eventually harms the investors. There is a name for such schemes, called "Ponzi scheme".
For further investigation and for history, some key words to google for are:
Ponzi scheme, high yield investment program, pyramid scheme, scam
