What is a Ponzi Scheme?

People were lining up for his firm’s investments. The results were visible, and people had been receiving high returns on what they put in. When asked how he was so successful, he said that he used the split-strike conversion strategy, which made his methods seem credible.

Even people who doubted Bernie Madoff were unable to prove that he was being unethical. Until November 2008.

With a major financial crisis ongoing, firms were losing money quickly and wanted to liquidate their investments with Madoff quickly. The problem is that he simply had no money anymore. He confessed to his family that he had just taken money from one person and offered unnaturally high returns to the next person, relying on people’s blind trust.

No money had been coming in to his firm for a while, and he owed investors billions of dollars. Bernie Madoff soon became notorious for executing the largest Ponzi scheme in history, spanning almost two decades.

But what is a Ponzi scheme? Let us find out exactly what it is and how to avoid it.

While Bernie Madoff ran the biggest and most famous Ponzi scheme, it was popularized by Charles Ponzi, after whom it is named. Ponzi would offer people an incredibly high return on investment, which would come from the money the next investor gave him. The scheme operates on the principle of stealing from someone else to pay another person.

People who run Ponzi schemes are incredibly intelligent and persuasive. They can convince others that the investments they are making are legitimate and lawful. Even experienced ones can fall for them as they may not be aware of specific loopholes, which the masterminds take advantage of.

Ponzi scheme operators lure people in with the promise of high investments and very little risk. They anticipate all potential questions and doubts and have answers prepared. When the person hands over the money, the scheme operator convinces them to ask their friends and family to also invest.

The money that comes from the next person is given to the first one, with the operator keeping a cut. The investor is immediately impressed and puts in more money, convinced that the high returns will be consistent.

This is what makes Ponzi schemes so dangerous. People actually receive money for a while; it isn’t a simple fraud where the scammer runs off with the money. The scheme looks genuine because returns keep coming. But this is just an illusion.

At some point, cash stops flowing into the scheme. Successful Ponzi schemes run for long periods because multiple people keep putting in money. Once the cash flow stops, the scheme falls apart and everybody who invested ends up losing their money.
Also Read: A Cautionary Tale for Senior Citizens on Online Stock Market Scams

• Guaranteeing high returns. No reputed investor will ever make promises of a guaranteed return. They will always caution their clients that investments are subject to market risks. There is no such thing as a guaranteed investment. Even veterans acknowledge that they can lose money, for which is a fact everyone needs to be prepared. If anybody claims that they will consistently bring high returns, never believe them.
• No information on where investments are going. Whether you choose to invest in stocks, mutual funds, bonds, or any other instruments, it is always clear how the money is used. If you don’t understand a particular type of investment, it makes no sense to pursue it. If someone is trying to push you into a certain investment but can’t give you the information on how it functions, they are dangerous.
• Vague strategies. People who run Ponzi schemes will have a strategy prepared when asked. But they will use a lot of financial jargon and complex information, relying on people’s ignorance to convince them. If the investment strategy makes no sense to you, don’t bother going ahead with it.
• Lack of paperwork. Legitimate investments will have proper paperwork. In general, financial dealings, especially with other people, will have a considerable amount. If someone comes up with an investment and there is no paperwork, it cannot be trusted.

Ponzi schemes are complex and multi-layered and can be easy to fall into. They provide the illusion of safety and reliability, until they disastrously fall apart, leading to people losing their money. However, with the right awareness, they can be spotted and firmly avoided.