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A Ponzi scheme is an investment fraud that pays existing investors with money collected from new investors, while claiming the returns come from a profitable investment. It collapses when new money stops covering what has been promised.
It is named after Charles Ponzi, who in 1920 in Boston promised 50% in 45 days, supposedly from trading international postal reply coupons. Early investors really were paid, with later investors' money, and word of their gains brought in thousands more. When newspapers and investigators looked into it in August 1920, the scheme fell apart; investors lost millions of dollars and Ponzi went to prison.
The largest known Ponzi scheme was run by Bernard Madoff, a former chairman of the Nasdaq stock market. For decades he reported steady returns of around 10% to 12% a year, in good markets and bad. In December 2008, as clients asked for about $7 billion back during the financial crisis, he could no longer pay and confessed. Account statements showed about $65 billion; the money investors had actually put in and lost was about $17 to $20 billion. He was sentenced to 150 years in prison in 2009.
The early returns in a Ponzi scheme are real money, which is what makes it convincing: the first investors can take out more than they put in. But nothing is invested, so every payout makes the pool smaller. To keep paying a fixed rate on everyone's money, the operator needs new deposits that grow faster and faster. When new money slows, or many investors ask for their money back at once, the pool runs dry, and the people who joined last lose the most.
Regulators such as the US Securities and Exchange Commission list warning signs: high returns with little or no risk, returns that are suspiciously steady, investments that aren't registered, sellers without licences, strategies that are secret or too complex to explain, and trouble getting your money out.
Payouts owed each period = promised rate × all the money in. With nothing invested: money left = deposits − payouts − withdrawals, so it lasts only while new deposits ≥ promised rate × all the money in + withdrawals.
Ten people put in $500 each at 20% a week: $5,000 in, $1,000 a week owed. With no new money, the whole $5,000 is paid back out as "returns" in five weeks. To keep going the operator must find $1,000 of new money every week, then more as the new money earns its own 20%. When it stops, the last people in lose almost everything, and the first may have doubled their money.
Chet Goldbridge's Guaranteed Growth Partners, by the casino in the city, promises 20% a week. Put in $50 to $500 of play money and he pays a seventh of that every day at noon UTC, out of the pool of investors' own money. He skips town when the pool can't pay or after 3 to 6 days, and the page shows who got paid and who lost. →
Ask where the returns come from. If the answer is secret, too complicated or "trust me", treat it as a warning sign.
Distrust steady high returns. Real investments go up and down; 20% a week, or even 1% a month every month for years, is a red flag.
Check that the investment and the person selling it are registered (in the US, with the SEC's EDGAR database and FINRA's BrokerCheck).
In the game, watch the reveal after Chet skips town: early investors who cashed out were paid with the latecomers' money.
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They're close cousins. In a Ponzi scheme, investors are paid by the operator out of other investors' money and think it comes from investing. In a pyramid scheme, members earn mainly by recruiting new members, who pay to join.
Because they really are paid, with the money later investors put in. That's what makes the scheme believable, and it's why the people who joined last lose the most when it collapses.
Nothing is earned, so promised returns can only come from new deposits, and the amount owed grows with every deposit. No pool of investors is big enough to keep that up forever, and any rush of withdrawals ends it sooner.
Sometimes some of it. In the Madoff case a court-appointed trustee recovered billions, partly by suing investors who had taken out more than they put in, so even some early winners had to pay back their "profits".
Which term is this?
“A ____ is when prices rise far above any reasonable measure of value because buyers expect to sell to someone else at a higher price, until confidence breaks and prices crash.”
Categories: Risk and strategy
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