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What is a Ponzi Scheme?

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What is a Ponzi Scheme?I worked a lot of low paying on-campus jobs when I was in college in order to support myself, pay my tuition, and graduate from college debt free.  Few people would envy most of the jobs I worked.  However, during my last two years in college, I worked a job that I absolutely loved: I was hired by a professor to research how individuals con other individuals using scams such as a Ponzi Scheme.

It was really fascinating stuff.  It helped me realize that I was very naive and could easily be conned myself if I was not careful.

One of the most successful and prolific scams that I researched was the Ponzi Scheme.

Ponzi Scheme

Contrary to popular belief, Charles Ponzi was not the first person to use the popular “rob Peter to pay Paul” investment con named after him.  However, his con was so large and received so much publicity, that all future scams of that nature were called Ponzi schemes.  Although there are numerous deviations of the popular swindle, most of today’s successful cons include features of a Ponzi scheme.

What is a Ponzi Scheme?

A Ponzi scheme is a classic “rob Peter to pay Paul” swindle.  The con artist will generally promise potential investors abnormally high investment returns in a short time period if they invest with him.  The swindler does not actually invest any of the funds that investors give him.  Rather, some of the funds are siphoned off for personal use and the rest are used to pay “returns” to earlier investors.

Investors believe that the money has been invested and is generating the promised returns since they are receiving regular payments.  In reality, there is no investment, no profits have been made, and additional funds must be raised in order to keep the swindle alive.

Some Ponzi schemes start out as a genuine business or investment.  However, once the company or investment reports dismal returns or losses, the executive or investment manager fudges the numbers to hide his actual performance.

Investors are happy with their earnings and tend to brag to their friends, who also want in on the great investment.  The new round of funds keeps the fraud alive a little longer.

When asked about how they generate such massive returns they may claim to have access to sophisticated software, advanced models, or financial arbitrage.  Others may claim that they cannot disclose their methods since they don’t want to lose their competitive advantage.

Why do People Fall for Ponzi Schemes?

Ponzi schemes are successful because people become greedy and are willing to ignore their common sense for a chance to earn a 150% guaranteed return in 25 days.  People want the opportunity to be legitimate so badly that they ignore their conscience.

Subsequent investors see it as a safe investment since the promised “returns” have already been paid to the initial investors.  As long as more money comes in than flows out, the fraud is perpetuated.  As long as investors continue to receive their promised “returns,” everyone is happy and most people are willing to ignore the tough questions.

Who are the Ponzi Scheme Perpetrators?

Ponzi perpetrators come in all shapes and sizes.  Some of these criminals do it because they can’t stand to fail.  Others do it because they want others to respect them, or they feel a need to be popular.  Many are quite delusional that they will eventually be able to pay back all of the money.

Many of these people exemplify such characteristics well before any crime is committed.  I even heard of one scammer who had his wife drive him to a college campus every day since he did not have the courage to tell her that he had flunked out of college many years before.

No Ponzi Scheme Lasts Forever

A Ponzi scheme must eventually collapse since liabilities are greater than assets from the very beginning.  New investors must consistently be brought to the table in order to support the ever increasing outflows to prior investors and the perpetrator’s own spending.

Fraudsters may try and extend the fraud by encouraging investors to automatically reinvest their returns in the venture in order to make even more money.  At some point, though, there will not be enough new investors to support the required outflows and the entire fraud will crumble.

Don’t Fall Victim to a Ponzi Scheme

Ponzi Schemes tend to share common traits with other scams:

  • Guaranteed high returns at no risk
  • Pressure to invest quickly
  • Secrecy

If someone approaches you with an “investment opportunity of a lifetime” that is guaranteed to produce outlandish returns in a short period of time with no risk, run away.  Even though you would love to make that type of money and would be thrilled if it were a legitimate investment, run away.

It just doesn’t make sense.  Risk free investments produce low returns.  If you want higher returns, you have to be willing to accept greater risk.  I have never seen an investment that is guaranteed to produce high returns at no risk.  That’s because they don’t exist.  If they did exist, nobody would have to beg you to invest in it.

Additional Ponzi Scheme Information

For additional information about Ponzi Schemes, check out the below books:

What are your thoughts about Ponzi Schemes?  Have you ever been approached about “an investment of a lifetime”?  Leave a comment below!

Image: gunnar3000/Bigstock


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