A Ponzi scheme is a fraudulent investing scam promising high rates of return with little risk to investors. The scheme leads victims to believe that profits are coming from legitimate business activity, while in reality, it involves the payment of purported returns to existing investors from funds contributed by new investors.
The Ponzi scheme is named after Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. Ponzi thought he could take advantage of differences between U.S. and foreign currencies used to buy and sell international mail coupons.
In a Ponzi scheme, the schemer, or “operator”, pays returns to its investors from new capital paid to the operators by new investors, rather than from profit earned through legitimate investments. The scheme is destined to collapse because the earnings, if any, are less than the payments.
Typically, the operator will vanish, taking all the remaining investment money (minus the amount paid out to investors) with them. Notable examples of Ponzi schemes include the activities carried out by Bernie Madoff and Allen Stanford.
Example of a Ponzi Scheme
Imagine there’s an investment firm run by a person named Mr. Smith. Mr. Smith promises investors a 20% return on investment (ROI) every month. This is a huge return compared to average market returns, which attracts many people who invest their money with him.
In the first month, Mr. Smith receives $1,000,000 from investors. At the end of the month, he needs to pay out $200,000 (20% of $1,000,000) to keep his promise. To do so, Mr. Smith finds new investors and collects an additional $300,000.
He pays the original investors their $200,000 from the new investment money, keeping the remaining $100,000. The original investors are thrilled with their high return and either reinvest their money or tell their friends about the opportunity, leading to more new investors.
This cycle continues with Mr. Smith using funds from new investors to pay previous investors while keeping the surplus. This all works fine until new investment slows down or too many current investors demand their money back at the same time. Mr. Smith won’t be able to pay them, the scheme collapses, and investors lose their money.
That’s a basic example of a Ponzi scheme. It’s important to note that Ponzi schemes are illegal and punishable by law, as they are a type of investment fraud.