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Ponzi Schemes:
What Are Ponzi Schemes and How Do They Work
Ponzi selling schemes are recognized by how they actually
work, not by how the promoters claim they work. The basic
operation of a Ponzi scam is commonly described as "robbing Peter to pay
Paul". Early investors in the scheme are paid with the money
invested by later investors. The later investors usually lose everything
when the scheme collapses; and all Ponzi schemes eventually do fail.
The Bernard Madoff case (which came to light in January 2009) is a
recent example that demonstrates that Ponzi schemes are still being
played and that both famous and intelligent people can be caught by
them, and lose their life's savings to scum like Bernie Madoff.
How to recognize a Ponzi scheme / scam
The Ponzi scheme usually offers abnormally high short-term returns
(usually 25% or greater) in a short period of time (3 to 9 months), in order
to entice new investors (victims). To keep the scam going an ever-increasing
flow of money from investors is required. If someone offers you a return
substantially greater than the prevailing bank, stock market and/or US Federal
prime interest rate, you can assume it is a scam. In recent history, the
best sustainable true rates of return from legal activities is in the 5% to 20%
annually. Most long term investors figure that 8% annually is an excellent
rate of return. "Doubling your money" in anything less that 5 years can
pretty much be assumed to be a scam, or based on illegal insider information.
Of course, there are exceptions to this, but they are rarely predictable; and
only seen in retrospect. We'll bet the odds of you
encountering a legitimate such return are about the same as being hit by an
asteroid while having dinner on your birthday.
Why all Ponzi schemes eventually fail
The problem with Ponzi's investment scheme is that it is difficult to sustain
this game very long because to continue paying the promised profits to early
investors you need an ever larger pool of later investors. The idea behind this
type of swindle is that the con-man collects his money from his second or third
round of investors and then beats it out of town before anyone else comes around
to collect. These schemes typically only last weeks, or months at most. There is
of course always the temptation to stay around just a little longer to collect
another round of investments--especially since each new round has to be bigger
than the ones before. But Ponzi made another, equally fatal, error. He became a
member of high society and once he had gotten the taste of this life, he
couldn't give it up.
The system is destined to collapse because the earnings, if any, are less
than the payments. Usually, the scheme is interrupted by legal authorities
before it collapses because a Ponzi scheme is suspected or because the promoter
is selling unregistered securities. As more investors become involved, the
likelihood of the scheme coming to the attention of authorities increases.
Background and history
 The
name "Ponzi scheme" comes from the person who first made this type of scam
famous: Charles Ponzi. Ponzi did not invent the scheme, but his operation took
in so much money that it was the first scam of this type to become known throughout the United
States. Ponzi emigrated from Italy to the United States in 1903. He soon became
a Boston investor broker. In 1920, Charles Ponzi became a relatively famous
millionaire in just six months using a scam in 1920. In the scam, profits were
supposed to come from exchanging international postal reply coupons (like modern
postage stamps). He promised a 50% interest (return) on investments in 45 days
or “double your money” in 90 days. The supposed source of this windfall
was the differential earned on trading in postal coupons, based on international
currency exchanges. The actual profit on the postal coupons never amounted to
more than a fraction of a penny each, but it didn't matter to Ponzi since this
was not the true source of his profits. About 40,000 people invested about $15
million all together. After the scam was exposed, only a third of that money was
returned to the investors/victims.
Ponzi opened his company, "The Securities Exchange Company," at 27 School Street
in Boston the day after Christmas 1919. He was penniless at the time and had to
borrow $200 from a furniture dealer in order to furnish his new office. Within
days he was collecting money from his initial rounds of investors. He then
expanded the circle of investors by collecting money from a larger round of
investors. When the bonds of the first investors came due he paid them, with
their miraculous profit, using the money collected from the second round of
investors. The news of these extraordinary profits swept up and down the east
coast and thousands of investors flocked to Ponzi's office for an opportunity to
give him their money. Using the money from this new surge of investors he paid
off the next round of bonds as they came due, with their full profit, which
excited even more frenzy.
During the heady days of the spring and early summer of 1920 Ponzi was the toast
of the northeast as people rushed to place their economic security in his
capable hands. As Ponzi himself described the result:
"A huge line of investors, four abreast, stretched from the City Hall
Annex . . . all the way to my office! . . . Hope and greed could be read in
everybody's countenance. Guessed from the wads of money nervously clutched
and waved by thousands of outstretched fists! Madness, money madness, was
reflected in everybody's eyes! . . .To the crowd there assembled, I was the
realization of their dreams . . . The 'wizard' who could turn a pauper into
a millionaire overnight!"
How do Ponzi Schemes, Chain Letters and Pyramid Schemes Operate?
The essence of the Ponzi scheme was that Ponzi used the money he received
from later investors to pay extravagant rates of return to early investors,
thereby inducing more investors to place their money with him in the false hope
of realizing this same extravagant rate of return themselves. This works only so
long as there is an ever-increasing number of new investors coming into the
scheme. To pay a 100% profit to the first 1,000 investors you need the money
from 2,000 new investors. To pay the same return to these first 3,000 investors
in the next round, you need the money from 6,000 new investors. If all the
investors stay in the scheme, then you will need 18,000 new investors to pay off
the first 9,000 investors. In fact, if all the investors stay in the scheme, the
number of investors participating has to triple with every round of investments.
In Ponzi's scheme, starting with only 1,000 investors, after the 15th round the
number of investors would exceed the population of the earth.
Round 1
Round 2
Round 3
Round 4
Round 5
Round 6
Round 7
Round 8
Round 9
Round 10
Round 11
Round 12
Round 13
Round 14
Round 15 |
1,000
2,000
6,000
18,000
54,000
162,000
486,000
1,458,000
4,374,000
13,122,000
39,366,000
118,098,000
354,294,000
1,062,882,000
3,188,646,000 |
In the classic chain-letter scheme 1 person gets, say, 10 people to make an
investment and each in turn get 10 additional people to invest, who then in
their turn must each get 10, and so on. The money for the first 10 "investors"
comes from the 10 they enroll, and the money for the second group of 10 comes
from the 10 investors that each of them enrolls, and so on. Diagrammatically,
such a scheme looks like a pyramid--hence its alternative name.
|
1
10
100
1,000
10,000
100,000
1,000,000
10,000,000
100,000,000
1,000,000,000
10,000,000,000 |
The reason that this is a scheme and not an investment strategy, is that the
progression it depends on is unsustainable. You must continually get more and
more new people into the system to pay-off the promises to the earlier members.
So if I promise to double your money, the only way I can do that is to get two
new people to give me the same amount you "invested," which I then pay to you as
your "profit." But now I have two new people, each of whom expects the same
pay-off. And to pay them, I need to get four new people. And to pay those four,
I will need eight more, and son on. After a few rounds of this kind of increase,
the number of new participants in the next round would be larger than the number
of persons on the earth. That's why all pyramid schemes must inevitably come
crashing down.
Related subject: Multi-level marketing
Multi-level marketing usually involves commercially viable (at least
somewhat viable) products (typically: clothing, jewelry, cosmetics,
health products, cookware) which present genuine business and
income-earning opportunities through repeat sales to clients. This
does NOT mean that MLM's are going to work for you, and many MLM's use
aspects of Ponzi schemes and thus border on illegal, and likely to be
unprofitable, except for early participants.
Clear Ponzi selling schemes often involve "gimmick" products (eg,
certificates) or grossly overpriced products or services that have
little or no resale value (such as many programs selling personal
development programs, pre-paid legal services, cosmetics, magazine
subscriptions).
See this page for more information about
Muilti-Level Marketing scams
Famous Cases and Examples of Ponzi Scams
Click here to see some names and examples of proven or banned Ponzi
schemes.
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