A Ponzi scheme is an investment scam where existing investors generate returns via money collected from new investors. The scam was named after Charles Ponzi, an Italian con artist who promised a 50% return within 45 days or a 100% return within 90 days on postal coupons in the 1920s. When something changes hands without a core underlying product or service, it might fall under a Ponzi scheme, thus requiring caution from potential investors.
- Understanding a Ponzi scheme
- Characteristics of a Ponzi scheme
- Ponzi scheme examples
- Key takeaways:
- Connected Financial Concepts
Understanding a Ponzi scheme
A Ponzi scheme is an investment scam where existing investors are paid with funds collected from new investors.
Ponzi’s scheme ran for over a year before his deception was uncovered, costing investors the equivalent of $258 million in today’s money. Though author Charles Dickens had written about similar scams as early as 1844, Ponzi received considerable press coverage on his arrest and he would be forever associated with the scheme.
The most nefarious element of a Ponzi scheme is the belief held by victims that profits are coming from proper business activities such as product sales or investment returns. In the process, they remain unaware that other victims are the source of the funds.
Ponzi schemes operators focus most of their efforts on attracting new investors. The scheme may run for as long as people continue to invest and are satisfied to the extent that they do not ask to cash out their investments.
Characteristics of a Ponzi scheme
In truth, many Ponzi schemes share a few common characteristics. These include:
Consistent (out of the market) returns
Legitimate investments tend to fluctuate in value as market values increase and decrease. In a Ponzi scheme, the investment appears to generate positive returns irrespective of market conditions.
Unlicensed sellers (usually not officially recognized)
Investment professionals are required under various state and federal laws to be registered. Many Ponzi schemes involve unlicensed investors who may claim to be representatives of a real or imagined company.
Difficulty receiving payments (illiquidity)
Despite the apparent success of the scheme, it can be difficult for participants to cash out their investment or realize gains. Some promoters may tempt them to remain in the scheme with the lure of higher returns in the future.
Secretive or sophisticated strategies (opacity)
The way con artists profit from the Ponzi Scheme is quite simple, but they describe the investment strategy to victims in terms or processes that are difficult to understand. Others will be vague or tell the individual to keep the investment a secret from family and friends.
Ponzi scheme examples
In the years since Charles Ponzi, investors continue to fall victim to Ponzi schemes despite increased awareness and information around the technique.
Here are just a few examples from the 21st century:
Greater Ministries International was an Evangelical Christian ministry headed by Gerald Payne. An IRS investigation in 2001 found that Payne had instituted a Ponzi scheme where almost $500 million was fleeced from 18,000 investors.
Stockbroker and investment adviser Bernie Madoff operated a Ponzi scheme in the asset management unit of his firm Bernard L. Madoff Investment Securities. The scheme was the largest in history and many believe it ran for decades. Estimates suggest Madoff collected $64.8 billion from approximately 4,800 investors.
Who used his Florida law firm to convince investors to invest in fake legal settlements. Rothstein collected $1.2 billion from investors and was later sentenced to 50 years in prison for his crime.
- A Ponzi scheme is an investment scam where existing investors are paid with funds collected from new investors.
- Some of the common characteristics of Ponzi schemes include consistent returns, unlicensed sellers, difficulty receiving payments, and secretive or sophisticated investment strategies.
- Ponzi schemes continue to occur in the modern age despite increased awareness around the practice. Investment adviser Bernie Madoff is the most notable example having collected almost $65 billion over many decades.
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