1. Education

What is a Ponzi Scheme? How Do Ponzi Schemes Work?

By

Question: What is a Ponzi Scheme? How Do Ponzi Schemes Work?
Answer: A Ponzi scheme is a scam investment designed to separate investors from their money. It is named after Charles Ponzi, who constructed one such scheme at the beginning of the 20th century, though the concept was well known prior to Ponzi.

The scheme is designed to convince the public to place their money into a fradulent investment. Once the scam artist feels that enough money has been collected, he disappears - taking all the money with him.

Five Key Elements of a Ponzi Scheme

  1. The Benefit: A promise that the investment will achieve an above normal rate of return. The rate of return is often specified. The promised rate of return has to be high enough to be worthwhile to the investor but not so high as to be unbelievable.


  2. The Setup: A relatively plausible explanation of how the investment can achieve these above normal rates of return. One often-used explanation is that the investor is skilled and/or has some inside information. Another possible explanation is that the investor has access to an investment opportunity not otherwise available to the general public.


  3. Initial Credibility: The person running the scheme needs to be believable enough to convince the initial investors to leave their money with him.


  4. Initial Investors Paid Off: For at least a few periods the investors need to make at least the promised rate of return - if not better.


  5. Communicated Successes: Other investors need to hear about the payoffs, such that their numbers grow exponentially. At the very least more money needs to be coming in than is being paid back to investors.


Steps in the Ponzi Scheme

Ponzi Schemes are quite basic but can be extraordinarily powerful. The steps are as follows:
  1. Convince a few investors to place money into the investment.


  2. After the specified time return the investment money to the investors plus the specified interest rate or return.


  3. Pointing to the historical success of the investment, convince more investors to place their money into the system. Typically the vast majority of the earlier investors will return. Why would they not? The system has been providing them with great benefits.


  4. Repeat steps 1 through 3 a number of times. During step 2 at one of the cycles, break the pattern. Instead of returning the investment money and paying the promised return, escape with the money and start a new life.


How Big Can Ponzi Schemes Get?

Into the billions of dollars. In 2008 we saw the fall of arguably the largest Ponzi scheme in history - Bernard L. Madoff Investment Securities LLC. The scheme had all the ingredients of a classic Ponzi scheme, including a founder, Bernard L. Madoff, that had a great deal of credibility as he had been in the investment business since 1960. Madoff had also been the chairman of the board of directors of NASDAQ, an American stock exchange. The estimated losses from the Ponzi scheme are in between 34 and 50 billion U.S. dollars. The Madoff scheme collapsed; Madoff had told his sons that "clients had requested approximately $7 billion in redemptions, that he was struggling to obtain the liquidity necessary to meet those obligations." (Source).

Comments or Questions on Ponzi Schemes?

You can leave them at this blog entry.

©2014 About.com. All rights reserved.