August 31

Definition Ponzi Scheme


 
 




 
 

The Man Behind The Name 


The ponzi scam is named after Charles Ponzi, a clerk in Boston who became famous (and ended up in jail) for orchestrating such a scheme in the 20’s. 

His scam amassed so much money that it was the first to become famous in the United States. Charles Ponzi’s original scheme was based on the arbitrage of international reply coupons for postage stamps.  

However, he quickly used investors’ money to pay earlier investors (and himself of course!).

Charles Ponzi

Charles Ponzi


 

How Does A Ponzi Scheme Work? 


A Ponzi scheme is a fraudulent investing scam that promises high rates of return with little risk to investors. The ponzi pays returns to its older investors from new capital paid by new investors. The short-term returns are either abnormally high or unusually consistent.

This scheme usually collapses on itself when the new investments stop. 

Ponzi schemes pop up frequently, though not all of them are big enough to make headlines. But every few years, a news story comes out telling how authorities have exposed an extensive and long-running Ponzi scheme. Two such exposed schemes (one that broke in 2006 and the other in 2008) were each reportedly bigger than any before them. Bernard Madoff, who orchestrated the most massive Ponzi scheme to date, conned about $35-50 billion from investors who came from all over the world.

The basic framework of a Ponzi scheme can be applied and reapplied in countless contexts. The scheme revolves around the process of paying old investors with the money you get from new investors. The central method remains the same. All one has to do is hook a few investors who are willing to get in early on a once-in-a-lifetime business venture. The details of the investment doesn’t matter too much. What attracts people is the promise of incredibly high returns on investments.

Ponzi scheme


 

Key Elements


  • Benefits : A promise that the investment will achieve an above normal rate of return. The rate of return is often specified. The promised rate of return has to be high enough to be worthwhile to the investor but not so high as to be unbelievable.
  • Successes : Other investors need to hear about the payoffs, such that their numbers grow exponentially. At the very least more money needs to be coming in than is being paid back to investors.
  • Setup : A relatively plausible explanation of how the investment can achieve these above normal rates of return. One often-used explanation is that the investor is skilled and/or has some inside information. Another possible explanation is that the investor has access to an investment opportunity not otherwise available to the general public.
  • Credibility : The person running the scheme needs to be believable enough to convince the initial investors to leave their money with him.
  • Initial Investors Paid Off : For at least a few periods the investors need to make at least the promised rate of return – if not better.

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Warning Signs


  • Fools rush in : Don’t let anyone pressure you into an investment. If you feel you’re being pressured, that’s all the more reason to suspect that something’s awry. Take your time in making your investment decisions.
  • Unrealistic returns : You’ve probably heard this piece of advice before, but it never hurts to repeat it — if it sounds too good to be true, it probably is. For the victims of Allen Stanford’s Ponzi scheme, that old adage certainly turned out to be correct. When you’re approached with an opportunity that seems unbelievably amazing, you should be highly suspicious. Investigate it as much as you can before you fork over any funds.
  • Steady as she goes : As with the Madoff scam, the returns in a Ponzi scheme don’t necessarily have to be unbelievable, so the previous tip won’t always help. However, many say that Madoff’s and victims should’ve been suspicious of how steady and consistent their returns were. They were always moderately good; real investments returns fluctuate.
  • Devil is in the details : If you do enter an investment, carefully examine what information the company provides. A suspicious lack of details should be a red flag  
  • High investment returns with little or no risk : Every investment carries some degree of risk, and investments yielding higher returns typically involve more risk. Be highly suspicious of any “guaranteed” investment opportunity.
  • Overly consistent returns : Investment values tend to go up and down over time, especially those offering potentially high returns. Be suspect of an investment that continues to generate regular, positive returns regardless of overall market conditions.
  • Unregistered investments : Ponzi schemes typically involve investments that have not been registered with the SEC or with state regulators. Registration is important because it provides investors with access to key information about the company’s management, products, services, and finances.
  • Unlicensed sellers : Federal and state securities laws require investment professionals and their firms to be licensed or registered. Most Ponzi schemes involve unlicensed individuals or unregistered firms.
  • Secretive and/or complex strategies : Avoiding investments you do not understand, or for which you cannot get complete information, is a good rule of thumb.
  • Issues with paperwork : Do not accept excuses regarding why you cannot review information about an investment in writing. Also, account statement errors and inconsistencies may be signs that funds are not being invested as promised.
  • Difficulty receiving payments : Be suspicious if you do not receive a payment or have difficulty cashing out your investment. Keep in mind that Ponzi scheme promoters routinely encourage participants to “roll over” investments and sometimes promise returns offering even higher returns on the amount rolled over.

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How To Avoid A Ponzi Scheme


Because they can take the form of any kind of investment, Ponzi schemes can be hard to spot.

When you consider your next investment opportunity, start with these five questions : 

  • Is the seller licensed?
  • Is the investment registered?
  • How do the risks compare with the potential rewards?
  • Do I understand the investment?
  • Where can I turn for help?

 

Known Ponzi


  • Bernard L. Madoff Investment Securities LLC (estimated losses in between 34 and 50 billion dollars)

Madoff auction for his victims

Madoff auction for his victims


 

The Fall Of A Ponzi


When a Ponzi scheme is not stopped by the authorities, it sooner or later falls apart for one of the following reasons:[1]

  1. The promoter vanishes, taking all the remaining investment money (which excludes payouts to investors already made).

  2. Since the scheme requires a continual stream of investments to fund higher returns, once investment slows down, the scheme collapses as the promoter starts having problems paying the promised returns (the higher the returns, the greater the risk of the Ponzi scheme collapsing). Such liquidity crises often trigger panics, as more people start asking for their money, similar to a bank run.

  3. External market forces, such as a sharp decline in the economy (for example, the Madoff investment scandal during the market downturn of 2008), cause many investors to withdraw part or all of their funds.

But as the cycle goes on, it gets more complicated. Earlier rungs of investors will get suspicious if they don’t continue to see returns. New investors will have to be paid back their initial investment, and the schemer will have to appease them with regular returns. This means that new investors will have to be added to the Ponzi scheme continuously in order to pay all the previous rungs. The schemer is under an enormous amount of pressure to keep adding investors, and one person can only do so much. (This is why the most successful schemes typically involve accomplices, but this merely delays the inevitable.) The scheme will eventually become unsustainable. The upside-down house of cards the schemer has built will finally collapse.

Tacoma-narrows-bridge-collapse

 
 




 
 

Ponzi schemes vs Pyramid Schemes


  • pyramid scheme is a form of fraud similar in some ways to a Ponzi scheme, relying as it does on a mistaken belief in a nonexistent financial reality, including the hope of an extremely high rate of return. However, several characteristics distinguish these schemes from Ponzi schemes:[1]

  • In a Ponzi scheme, the schemer acts as a “hub” for the victims, interacting with all of them directly. In a pyramid scheme, those who recruit additional participants benefit directly. (In fact, failure to recruit typically means no investment return.)
  • A Ponzi scheme claims to rely on some esoteric investment approach and often attracts well-to-do investors, whereas pyramid schemes explicitly claim that new money will be the source of payout for the initial investments.
  • A pyramid scheme typically collapses much faster because it requires exponential increases in participants to sustain it. By contrast, Ponzi schemes can survive simply by persuading most existing participants to reinvest their money, with a relatively small number of new participants.

A Ponzi scheme is similar to a pyramid scheme in that both are based on using new investors’ funds to pay the earlier backers. One difference between the two schemes is that the Ponzi mastermind gathers all relevant funds from new investors and then distributes them. Pyramid schemes, on the other hand, allow each investor to directly benefit depending on how many new investors are recruited. In this case, the person on the top of the pyramid does not at any point have access to all the money in the system.

For both schemes, however, eventually there isn’t enough money to go around and the schemes unravel.

 

Pyramid Scheme

Ponzi Scheme

Typical approach

Earn high profits by making one payment and finding others to become distributors of a product. The scheme typically does not involve a genuine product. The purported product may not exist or it may be “sold” only to other people who also become distributors.

Earn high investment returns with little or no risk by simply handing over your money; often the investment does not exist or only a small percentage of incoming funds are actually invested.

Payments

Must pay a one-time or recurring participation fee and recruit new distributors to receive payments.

No recruiting necessary to receive payments.

Interaction with original promoter

Sometimes none. New participants may enter the pyramid scheme at different levels.

Promoter generally interacts directly with all participants.

How the scheme works

Funds from new participants are used to pay recruiting commissions to earlier participants.

Funds from new investors are used to pay purported returns to earlier investors.

Collapse

Fast. An exponential increase in the number of participants is required at each level.

May be relatively slow if existing participants reinvest money.

 

In A Few Words


A ponzi scheme operates as follow :

  1. It will convince a few investors to place money into the investment
  2. After the specified time it will return the investment money to the investors plus the specified interest rate or return.
  3. It will point to the historical success of the investment, convince more investors to place their money into the system. Typically the vast majority of the earlier investors will return. Why would they not? The system has been providing them with great benefits.
  4. It will repeat steps 1 through 3 a number of times. During step 2 at one of the cycles, break the pattern. Instead of returning the investment money and paying the promised return, escape with the money and start a new life.

 

If you have been scammed by a Ponzi feel free to share your experience within the comment area ; I’ll be more than happy to connect! Also if you are interested in building a sustainable online business I suggest you check out my #1 recommendation

Thanks for dropping by! 

Cheers =)

Sarah
 
 




 
 

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