What Is a Ponzi Scheme?

Ponzi Schemes Explained

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A Ponzi schemes is a fraudulent investment. Investors are invited to put their money in a fund that looks too good to be true, promising high rewards for very low risk.

A Ponzi scheme is never a legitimate investment. never legitimate ones. Learn more about how they work and how to spot them.

Definition and Examples of a Ponzi Scheme

A Ponzi scheme is a fraudulent investment. They often promise very high returns, no matter what the economy or stock market are doing.

At first, they make good on these returns. They use the principal investment from new investors to make the above-average returns to the old investors.

After paying these returns, they use all their resources to get new investors. The people running the scheme will also take money for themselves.

Eventually, these schemes fall apart. They cannot keep recruiting enough new people to continue paying returns to the old investors. 

One of the most well-known Ponzi schemes was run by Bernie Madoff. He conned investors out of billions of dollars.

His scheme was exposed during the 2008 financial crisis when investors tried to withdraw their money and couldn't.

How Do Ponzi Schemes Work?

A Ponzi scheme will claim to be an investment opportunity. But there is actually no investment happening.

Often, the people running the scheme will say the business they are investing in is too complicated to explain. There will be no legal paperwork for investors to look at to understand where their money is going.

A Ponzi scheme uses the money "invested" by new participants to pay existing investors. That's why they must keep recruiting new investors. If new members stop joining, they can no longer pay anyone.

Investors who get trapped by Ponzi schemes often find it difficult to get their money back.

Is Social Security a Ponzi Scheme?

Workers in the United States pay into the Social Security Trust fund. Despite the name, there is no trust holding these funds for them.

Instead, the funds pay benefits to existing retirees. Once the paying workers are ready to retire, new funds will come from new workers.

People occasionally call Social Security a Ponzi scheme because the people who got in early are receiving more than they paid in. Baby boomers paid more payroll taxes than the contributions received by their parents. This is not the case for retiring boomers.

There will not be enough workers in the future to pay benefits to them when they retire. By 2030, Social Security will need to draw from the general fund to pay out benefits. That will create a budget deficit or a need for new taxes.

This means the government will force the next generation to pay for benefits. Unlike a Ponzi scheme, the "new investors" have no choice. That's the difference between Social Security and a Ponzi scheme.

Notable Happenings

Charles Ponzi

Ponzi schemes are named after Charles Ponzi. He was a con man who fooled thousands of investors in the 1920s.

Ponzi promised a 50% return in 90 days on profits made from international reply coupons. These coupons were slightly less in value in foreign countries. They could be redeemed for real stamps higher in value in the home country.

The profits seemed plausible to gullible investors. But it would have required millions of coupons to make any profit at all. Instead, Ponzi used the funds he acquired to pay off a few early investors in 45 days.

This made his proposal believable. In a few months, he collected $20 million. He once received $1 million during a three-hour period.

The Ponzi scheme crumbled when he was unable to pay off later investors. By then, he had lost between $7 million and $15 million and ruined six banks. The government charged him with mail fraud under state and federal law.

Charles Ponzi received a prison sentence of five to nine years. He jumped bail and proceeded to launch the Charpon Land Syndicate in Florida where he sold real estate that was underwater. Texas authorities kidnapped him and returned him to Boston. He was released in 1934.

Bernie Madoff

Bernie Madoff operated the longest-running Ponzi scheme to date. For 20 years, investors poured $17.5 billion into his "investment firm".

Madoff paid above-average returns using funds from new investors. The 2008 financial crisis brought his fraud to light.

Investors tried to withdraw $7 billion. But with a net worth of only $300 million, Madoff was unable to pay them.

He pled guilty in 2009 and was given a 150-year prison sentence. Before the sentence ended, Madoff passed away on April 14, 2021, in federal prison due to reported natural causes. He was 82.

Prior to his arrest, Madoff was a chairman of NASDAQ, where he had a shining reputation.

The charges for the fraud did not extend to the other members of the Madoff family. His wife and two sons worked for related businesses in separate buildings.

The courts allowed Ruth Madoff to keep $2.5 million. She moved to a 989-square foot apartment in Connecticut.

Ezubao

Chinese authorities announced the most recent example of a Ponzi scheme in February 2016. One million investors lost $7.6 billion to Ezubao, an online finance company.

Ezubao falsely promised 15% returns. Instead, the 21 owners spent money from investors to run their company and buy luxury cars and houses. Ezubao operated from July 2014 to December 2015.

Ponzi Scheme vs Pyramid Scheme

Ponzi schemes and pyramid schemes often get mixed up with each other. But there are key differences in their structure and purpose.

 Ponzi Scheme  Pyramid Scheme
Fraudulent investment Fraudulent multi-level marketing (MLM) business
Investors believe they are participating in a real investment Participants must recruit new members to make money
Money "invested" by new participants is used to pay old participants Members at the top level of the pyramid make money from new recruits at lower levels, new recruits struggle to make any money 
If the person running the scheme is not caught, investors are left with nothing New recruits must either recruit new members or give up, having wasted their time and money

Are There Legitimate MLM Companies?

Most well-known MLM companies are not pyramid schemes. Amway, Melaleuca, and PrePaid Legal are all real businesses, not schemes.

These companies get most of their revenue from products or services, not new customers. Most of their customers are also not representatives of the company. This is the main difference between an MLM business and a pyramid scheme.

Legitimate MLM businesses are a good option for people who want to learn how to run their own ventures. Learn to ask the six important questions when someone invites you to join an MLM. The answers may help you discern a scam from a real business offer.

What It Means for Individual Investors

You can avoid being duped by a Ponzi scheme by always doing your due diligence before investing.

Look into the history of the investment firm, including its financial records and the records of the companies where it invests. Legitimate firms will always make this information public and easy to access.

If there are no or few legal records to look at, it's a warning sign that you should steer clear. If a broker tries to rush you into investing or says the opportunity is too complicated to explain, there's a good chance the investment is a fraud.

Legitimate investment firms will not guarantee returns under all conditions or promise that there is no risk involved. If something seems too good to be true, it probably is.

Key Takeaways

  • A Ponzi scheme is a fraudulent investment that promises high returns at very low risks, no matter what the economy is doing.
  • Often the workings of the business opportunity are too complicated to explain, and there is no legal paperwork for the investor to look at.
  • The scheme relies on an influx of new investors to make money for old investors because there are no real profits being generated.
  • Investors who get trapped by Ponzi schemes may never be able to get their money back.
  • If an investment opportunity seems to good to be true, it probably is.