What is a Ponzi Scheme? I like to say that Ponzi Schemes are Pyramid Schemes gone haywire. And though some people think that all pyramid schemes are Ponzi schemes, that isn’t true at all.
Ponzi Schemes circle around an investment offer that is usually “to good to be true”. There is no pyramid, just a scheme to get investors, and then get more investors, allowing payment of earlier investors from monies paid by later investors.
Let’s dive a little deeper.
Who is Ponzi?
Though scams and schemes existed prior to the 1900’s, it wasn’t until the 1920’s that the act of “borrowing from one pocket and putting it in another” was named.
The infamous Charles Ponzi, an Italian immigrant who went by a number of pseudonyms, became the “King of Swindle”. He promised unsuspecting clients a 50% return on their money within 45 days, or 100% within 90 days by purchasing postal reply coupons in other countries and redeeming them in the US as a type of arbitrage.
In reality he was paying earlier investors with monies received from later investors. He was so known for it, that this type of activity was named for him – the “Ponzi Scheme”. He ran his scam for over a year, fleecing investors of over $20 million. In reality, it is reported that he spent no more than about $30 on stamps.
An earlier scheme – and perhaps the model from which Ponzi developed his scheme – was carried out by William F. Miller in 1899. Miller, also known as “520% Miller”, was a bookkeeper who used a similar deception to defraud people of $1 million.
How Does It Work?
A Ponzi Scheme is a form of fraud in which investors are told of an opportunity to invest in a non-existent business entity. They are promised quick returns on their investment. Monies paid to first investors come from money invested by later investors.
Often those who are able to carry this type of scheme off are well-known, trusted financial advisors or those who would possess “insider information” on investment opportunities.
You can see how something like this will eventually fall apart. Any changes in the economy can cause everyone to want their investment back, as is what happened in the now famous Bernie Madoff Scandal.
Watch this 3-minute video for a short primer:
Today’s “Ponzi Poster Child”
There is not a person alive who doesn’t remember the Bernie Madoff scandal. The investment fraud came to light in December 2008 as the stock markets took a tumble and nervous investors wanted their money.
Madoff was the former chairman of NASDAQ and was the founder of Wall Street’s then-prestigious Bernard L. Madoff Investment Securities, LLC. He was obviously well respected AND well connected to wealthy individuals. However, some who were middle class folks invested everything with him and lost it all.
It was in December 2008 that he admitted that the wealth management arm of the business was an elaborate multi-billion-dollar Ponzi scheme.
His own sons alerted federal authorities, and the rest became history. Madoff was sentenced to 150 years in jail – perhaps not even long enough for those who lost a fortune.
How to Spot a Ponzi Scheme
There are a few “red flags” you can look for:
- Check to see if the investments are registered with the SEC
- Is the seller licensed to sell investments? Law requires that individuals working in securities firms be licensed. Schemes are often carried out by unlicensed individuals.
- High investment with little or no reported risk – every investment carries risk to some degree
- Overly consistent returns – investment returns tend to go up and down
- Secretive or complex investment strategies – avoid investments that you do not understand
- Issues with paperwork – do not accept excuses with regard to proper paperwork
- Difficulty receiving payments – be suspicious if you have a problem cashing out your investment.
The Bottom Line
If it seems to good to be true, it probably is, even if the person offering the deal is famous or well-known. Period.