The Ponzi Scheme: A Dangerous, Illegal, and Immoral Way to Get Rich

A "Ponzi Scheme" is a type of investment scam in which the scammer promises an unusually high rate of return on investment to attract investors and then pays the return out of the money received from later investments. The Ponzi scheme is named after Italian swindler Charles Ponzi, who bilked $15 million out of the citizens of Boston in the summer of 1920 before his scheme collapsed.

The Ponzi scheme is often confused with the "pyramid scheme," but while there are similarities, the two schemes are actually different. While both schemes promise an impossibly high return on investment, the Ponzi scheme typically has a single fraudster who acts as a hub of the scheme, manages all of the money, and interacts with all of the investors, whereas a pyramid scheme typically relies on individual investors to recruit new participants.

Furthermore, whereas a Ponzi scheme usually hides its mechanics behind the ruse of a legitimate investment, a pyramid scheme explicitly informs participants that their return will come from the entry fees of new members.

Finally, whereas a pyramid scheme is bound to collapse very quickly because its exponential growth is unsustainable, a carefully crafted Ponzi scheme can often be maintained for years or even decades, as investors are typically induced to reinvest their returns (without any money actually changing hands) for the promise of even greater returns. In fact, the inducement of participants to reinvest their returns can probably be considered the hallmark of the Ponzi scheme.

How it works

To start a Ponzi scheme, the swindler first comes up with a plausible-sounding investment scheme which he can pitch to investors. In some cases, the schemer himself initially believes in the scheme, and actually does try to invest the initial money in the way he has claimed, and the Ponzi scheme only develops later when he cannot pay the promised return.

The scam begins when the schemer has to pay out the return, but rather than paying it out using actual assets, pays it out using money received from later investors. The payment in cash of the promised high return secures the trust of the initial investors, who then reinvest larger amounts of money, and spread word of the venture to other investors.

As more and more investors join the scheme, the schemer comes under increasing pressure to secure new investment to keep paying out when demanded and huge liabilities start accumulating. At this point the schemer begins encouraging investors to reinvest their returns with him rather than receiving cash, in order to reduce the amount he has to pay out. As long as he can keep getting new investors and keep getting old investors to reinvest their returns, the schemer can keep the scam going for a prolonged period, often profiting handsomely himself on the difference between the incoming investment and the payouts, and as long as he keeps paying out whenever he is asked, becomes increasingly trusted and even loved by his investors.

How it ends

Ponzi schemes can end in one of three ways:

1. The schemer disappears, running off with whatever money he was able to accumulate from the scheme.

2. The scheme eventually collapses under its own weight, as the people asking for their promised return increases or new investment decreases to the point where the schemer has trouble paying out what he has promised. At this point investors panic, and there is a run on the schemer who is then exposed as the fraud that he is.

3. The scheme is exposed when somebody (a reporter, a rival, the government, etc.) begins poking around and finds proof that the type of investment the schemer claims to be conducting is not actually occurring.

Since Charles Ponzi, Ponzi schemes have become increasingly sophisticated, and in recent years people have been able to maintain Ponzi schemes for longer and longer periods, and earn larger and larger sums of ill-gotten money. Charles Ponzi was not the first to run such a scheme, and there were several proto-Ponzi schemes before he arrived on the scene in 1920, but he was the first to rely so heavily on inducing investors to reinvest their returns, which is the key to keeping the scheme running for a long, long time. But whereas Charles Ponzi promised truly ridiculous returns (50 percent in only 40 days), thus insuring that his scheme would collapse sooner rather than later, the schemers who followed him have recognized that the other key to keeping a Ponzi scheme going is to promise a more plausible return that is only slightly higher than that offered by one's competitors.

This mechanic is well understood today, and if anything, Ponzi schemes seem to be cropping up more frequently, and often never actually collapse, only ending when they are uncovered by authorities. The recent discovery by of the largest Ponzi scheme ever uncovered to date - a $50 billion swindle perpetrated on very reputable investors by highly respected Wall Street insider Bernard Madoff - testifies to just how long these schemes can run and just how big they can get.

As long as one can keep it going, the temptation to resort to a Ponzi scheme for someone who knows how to do it is very high, whether because the schemer can pay himself a handsome salary while earning the respect and admiration of his peers, or because he just wants to avoid the embarrassment and blow to his reputation of having his attempted investment be known to have failed. Although several Ponzi schemes have been uncovered in recent years, it would be naive to assume that there are not numerous Ponzi schemes going on right now as you read this, and investors should always be wary and conduct due diligence on any investment that promises a return even slightly higher than could reasonably be expected.