The Real Reason MMM Crashed: The Tradeoff Between Risk And Return

All investments carry risks to varying degrees. It is important to determine your risk threshold before investing

It seems just like yesterday when MMM and many other exciting Ponzi schemes hovered around the Nigerian finance space. Everyone was talking about how amazing their returns were! For some, it was the best thing in the world and for others, it was definitely too good to be true.

“If you put N100,000 now, you’ll get N130,000 by the end of the month!” Some even went as far as completely doubling your money in two weeks! If you were actively in Nigeria around that time, then stories like “A friend of mine bought a new car and started business with his gains from MMM” would have filled your ears like aroma to your nostrils.

And if you had caved in, your story would be either that you luckily stopped before the day it crashed, or you would have lost some major money you are probably still not proud of.

There is a reason investment as those are known as Ponzi schemes. Not only do they offer unsustainable returns, their foundations are wrong.

In fact, the dictionary definition of Ponzi scheme is “a form of fraud in which belief in the success of a non-existent enterprise is fostered by the payment of quick returns to the first investors from money invested by later investors.”

The managers of the account simply collect monies of new investors and use them to pay up older investors. It was bound run dry eventually because the risks involved were as high as smuggling illegal drugs through airport customs.

__Understanding risk and return__

The tradeoff between risk and return is captured in a very common phrase: The higher the risk, the higher the return and vice versa.

The interesting thing about risk is its probabilistic element that can swing both ways. In other words, there is no guarantee that you will actually get a higher return by accepting more risk.

This tradeoff is one of the oldest and most relevant principles of not just investment, but also life. History is replete with men and women who took bold steps, risking it all for success. They took huge jumps to reach their Eldorado, and while those who made it lived to tell their story, many didn’t.

In the same vein, many of the greatest investors had to take immense risks to amass the level of wealth they got; but, if you’ll dig deeper, they have also lost the most monies. “No pain, no gain.”

Interestingly, all investments carry some degree of risk.

First, while treasury bills, certificates of deposit, and savings accounts would guarantee your principal because they are backed by the government and financial institutions respectively, their interest rates are known to be below the inflation rate, ultimately reducing their long-term value.

The upside is that your principal is safe, but the downside is that you wouldn’t make as much money – not even enough to cover the effect of inflation.

Another relatively safe investment vehicle is the one involving liability. Bonds are loan agreements between the bond issuer and an investor, in which the bond issuer is obligated to pay a specified amount of money at specified future dates.

They have a higher return, are riskier than treasury bills and savings accounts but not as risky as equity investments. They are prioritized at the point of interest payments or at bankruptcy over equity investors but will not nearly make as much money as the ordinary shareholders.

More so, they also have their risks as their prices may drop if the issuer’s creditworthiness declines or interest rates rise.

Last on this chain are stock investments. Stocks have potentially higher return than bonds in the long term. However, stockholders can lose everything if a company goes bankrupt. On the other hand, if the company is successful, they can make a lot more profit than expected. This is why they are regarded as the owners.

Factors that determine risk typically include market volatility, inflation and knowledge.

While you might not be able to control the movement of the market, there is so much that information can save you from. Risk in itself cannot be eliminated, but it can be managed by holding a diversified portfolio of assets (more on this in future posts).

However, the first thing to do when investing is to determine your risk threshold. It is also very important to know exactly what you are putting your hands into because as MMM showed many people, there is a thin line between investing and gambling.

[Article by Lawretta Egba]