Scams, Schemes, and Scum: Ponzi Schemes

All this week, I’m going to be taking a closer look at many of the tricks and techniques used by men and women with questionable ethics in order to take money from innocent people, whose ranks include my readers (I hope…).  In order to help you fight against these charlatans, we’re going to look closer at some of the most popular techniques used to separate you from your money.  First on the agenda is the Ponzi scheme, which has been getting a lot of attention due to recent purveyors of this rather old scheme.

The Scheme

A basic Ponzi scheme works like this: investors are convinced to invest with the schemer, usually as a result of clever marketing and promises of unrealistic investment returns (doubling your money, risk-free, in ninety days, for example) in an unorthodox investment arrangement.  A small number of investors form the first group, putting their money into the investment.  They receive the promised returns, paid from their own deposited money, and word spreads of the lucrative opportunity to become rich offered in the schemer’s investment.  A steady influx of cash ensures that the payouts continue, drawing in an even greater amount of investment money, forming an endless circle.  Endless, that is, until the scheme collapses under its own weight, unable to get enough new money coming in to cover the payouts or having the funds depleted by withdrawals.

Historic Ponzi Schemes

William Miller – Offering a ten percent weekly return, he earned the nickname ‘520 percent’ and a ten year prison sentence, years before Ponzi came on the scene.  (Which means all you Millers out there can breath a bit easier; if William’s scheme had been more famous, you might be reading an article on ‘Miller Schemes’ right now.)
Charles Ponzi – The man who lent his name to this whole class of schemes, he claimed to increase your money by 50% within 45 days or double it in 90, all by buying foreign stamps and reselling them in the US.  He ended up in prison for much of his adult life, as a result of this and other wrong-doing.
Bernard Madoff – The most famous recent example of a Ponzi scheme, he ran an investment fund that ended up being busted during the fall of 2008, leading to criminal charges against him at the end of 2008.  As a result of the huge size of this fraud (and the fact that his last name is pronounced ‘Made Off’, lending itself nicely to ‘made off with all my money’ comments) ,he is one of the most talked about Ponzi schemers.

An Example Scheme

Let’s say I decide to run a Ponzi scheme.  I advertise that for a mere $10,000 minimum deposit, I can provide you a ten percent return each week (repeating Miller’s claim, basically) from a scheme involving hedging pork bellies with soy beans, or whatever scheme I think will catch people’s attention.  I get ten initial investors, and at the end of the week, I dutifully return 10% of their money, which I call the ‘investment proceeds’.  In reality, all I’ve done is take their money and give part of it back to them, but make them think that the entirety of their cash is still being invested.

With the fame I derive from these first ‘investments’, suddenly there are even more investors lining up to give me money.  The problem is, eventually the whole thing catches up on me.  Even if I get ten new investors with each week, after ten weeks, they will think I’ve got their money, even if after ten weeks, I only have half as much cash as I’ve led them to believe, or after nineteen weeks, when I run out of investor money to pay everyone (sooner, if I take part of the incoming money for my own profits):

Ponzi At Work
Ponzi At Work

As you can see, the real value of money I have in my ‘fund’ is always less than the amount people have added to my scheme, and eventually, the difference becomes so large that the fund is essentially bankrupt.  The only solution is to get the number of people who donated each week to increase; but even in that case, eventually the funds will run out, and everyone will realize I don’t have their money held safe, steadily making profits.

How to Protect Yourself

Become Financially Educated – The best defense against Ponzi schemes, as well as most other types of scams in the investment world, is to have at least a basic financial understanding.  If you learn about stocks, bonds, mutual funds and other investments, and have an understanding of the amount of return you can get from them, you’ll be able to look at the pitches of a Ponzi scheme and realize how absurd they sound.  Which brings us to our next tip to protect yourself…

Maintain a Healthy Skepticism – It’s easy to look at some of the promises offered by Ponzi schemes (1o% weekly returns, doubling your money in ninety days, etc.) and get caught up in emotion, investing your money to chase wealth.  Instead, consider such dramatic claims as enticements, and do your own careful research.  If it doesn’t seem like the specifc advice you’ve encountered on the types of investments touted by a sales person is right, don’t make a purchase.  That’sa ll there is to it.

Diversify Your Portfolio – While this is not advice specific for dodging Ponzi schemes, per se, but  it’s an important part of any financially responsible family.  If you have all your money in one place, it’s easier for your money to disappear should the investment turn out to be part of a Ponzi scheme.  No matter what returns are being offered, be sure to split up your money, to keep one bad egg from crushing your nest egg.

That’s all for Ponzi schemes.  Turn in next time, same financial time, same financial station!

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