What is a Ponzi Scheme?

by Natalie MacLellan on August 31, 2009

in Fraud Prevention

Despite the heightened awareness of Ponzi schemes following Bernard Madoff’s multi-billion dollar fraud and 150-year prison sentence, these scams continue to trap investors. It should come as no surprise that Ponzis made the list of the top 10 investor traps of the year.

The term Ponzi is named after Charles Ponzi, who became known for the fraud he operated in the 1920s. Ponzi did not invent the tactic but his scam took in large amounts of money and became the first high profile case.

A Ponzi is a type of investment fraud. It is promoted as an investment which generates interest, profit, or other income. Often the promoter will use fancy financial lingo to make the opportunity sound impressive to novice investors, or will insist it is a proprietary investment and should be kept secret.

The catch of course, is that the investment either doesn’t exist or isn’t viable enough to generate the profit that is being promised. The money that investors receive is paid from money received from new investors recruited into the scheme, not the returns from the supposed investment.

Because early investors receive initial high returns, they are likely to be convinced of its legitimacy, reinvest more funds to the scheme, and even convince family and friends to do the same. After all, it does pay out higher than any alternative investment.

The returns that a Ponzi scheme pays require an ever-increasing flow of money from investors to keep the scheme going. The system is doomed to eventually fall apart because there are no underlying earnings and the pool of new investors cannot grow forever. Eventually, the promoter runs out of money to pay new investors, and is either discovered as a fraud – or disappears before this can happen.

While some Ponzi investors may have a slight chance of realizing a return on their investment, most investors have from the outset no hope of recovery. The Ponzi scheme is the securities world’s equivalent of a purse snatch.

This post featured in the Carnival of Personal Finance 221 on September 8, 2009.

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