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Understanding Ponzi Schemes

Ponzi schemes have been used to bilk investors out of their hard earned cash for many years and are in the news again. The recent exposure of the Ponzi scheme that was allegedly run by Bernard Madoff is just another example of how effective this con can be, and how easily people can be tempted by the lure of easy money.

In order to better understand how a Ponzi scheme works, a little history might be helpful. The term “Ponzi scheme” originated with the scandal that surrounded this con being run by Charles Ponzi in 1920. He was so effective at drawing investors in with his promise of amazing returns that he went from rags to riches in a short six months. In that time he amassed over a million dollars and involved people from across the United States in the con. The reason the scheme is named after him is because even though it had been run for years by others, his was the first to reach such a scale nationally. His version of the scheme was a form of arbitrage based on international postal reply coupons (IRC) that promised returns of 400% or better to investors.

The interesting thing about Ponzi schemes is that they are basically the same con each time they are used. The key to their amazing success, and any good con really, hinges on the folks involved trusting the person running the scheme. In the case of the Ponzi scheme, this trust is created in several ways. For the purposes of this article we will refer to the person running the scheme as the “crook” and the person being cheated as the “victim”.

The way the scheme works is that the crook approaches a victim with the promise of amazing returns on a little known deal that he would like to offer the victim a chance to get involved with. This initial offer is usually for a modest amount of money, with a very short return on that investment. This is a critical step in the scheme and how the crook sets the bigger trap. The victim will invest in the deal and when the maturity date of the investment arrives, he will be paid the returns he was promised. This important step does two things. First, it entices the victim to invest again in the deal to further increase his profit.


  • The pool of new investors is not expanding quickly enough to cover the payments needed for the maturity of the other investors. At this point the crook will usually take the money and run, leaving the investors without their money. This is a really bad outcome for the investors.

      • The crook decides they have enough money and disappears. This leaves the investors without their money as well, and looking to have a nice long conversation with the person who recommended the investment to them. This again is really bad for the investors.

          • Authorities uncover the scheme, grab the crook and shut it down. This happens quite often when these schemes are run nowadays since there are a lot of regulatory agencies that can sniff these type of scams out with the help of the internet. This is the best possible outcome for investors since they may recover a portion of their investment.
            • So now that you better understand how a Ponzi scheme works and how to avoid one, be careful with any investment that fits this pattern. If an investment is recommended by a friend, take the time to investigate it fully and talk to others outside of the investment to get another reasonable perspective. The legitimacy of most investments can be easily verified with a little digging on the web and could save you a lot of money and embarrassment. The next time someone approaches you with the “deal of a lifetime” and wants to offer you an opportunity to “get in on the ground floor”, check it out before you invest your hard earned cash. Also be sure to visit our scams section to find out about other ways investors lose their money.

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