You want to build wealth and achieve financial success, and I get it. There's nothing wrong with that, and you're not alone.
But in the pursuit of financial security, it's important to be aware of the dangers lurking in the investing world. Ponzi schemes, in particular, have a way of luring in unsuspecting investors with the promise of high returns and quick riches.
It's easy to understand why so many people fall victim. After all, who wouldn't want to make massive returns on their investment?
But the truth is, Ponzi schemes are fraudulent and leave most investors with massive financial losses. Not gains. And that's just the beginning.
Add in the emotional turmoil and potential legal consequences, and it becomes clear why understanding how Ponzi schemes work is so important.
In this article, we'll go over the life cycle of a Ponzi scheme, the math, and the consequences of participating in them. The better understanding you have of how Ponzi schemes work, the better chance you have of protecting yourself from them.
What is a Ponzi Scheme?
A Ponzi Scheme is a fraudulent investment scheme named after Charles Ponzi. It typically involves investors receiving unusually high returns for a short period of time, giving the illusion of profitability.
But in reality, these returns are not from real investments or business activity; they are simply paid out from capital deposited by new investors.
Those participating in the scheme often will be unaware that it is fraudulent; they may believe they are getting genuine profits.
This investing model relies on continually bringing in more funds from new members to pay off earlier members and prolong the illusion of success and profitability. Ultimately, as more people try to withdraw their money, the pyramid collapses, and those still invested lose everything.
Charles Ponzi
Charles Ponzi was an Italian-born fraudster who went under multiple aliases, including Charles Ponci, Carlo, and Charles P. Bianchi. During the 1920s, he was known in the US and Canada as the swindler.
Boston Library (NYT); en.wikipedia.org, Public domain, via Wikimedia Commons
Ponzi promised investors enormous returns on their investments in a short period of time. He claimed that he could take advantage of differences in currency exchange rates to buy and sell international postal reply coupons at a profit. It was believable but untrue.
Instead, Ponzi was using the money from new investors to pay off earlier investors without actually investing the money as he had promised. This is how his scheme became known as the Ponzi scheme. And, as is typical with this scheme, it eventually collapsed when Charles could not find enough new investors to keep the scheme going.
Ponzi's scheme resulted in huge financial losses for investors and ruined many people's lives. He was eventually caught and sent to prison for his crimes, but his name has since become synonymous with investment scams of this nature.
How Do Ponzi Schemes Work?
Ponzi Schemes rely on the promise of high returns, which should be a red flag for anyone. But we are all human; if not greedy, we all at least have goals, dreams, and desires.
We want more out of life, and for right or wrong, money can help us get it.
So even though we know better, it's hard to resist imagining what it would be like. And when offered an opportunity, even if we suspect something might not be legit, even the best of us can ask the question,
“What if?”
And that very question is what Ponzi Scheme operators prey upon. It's how they get away with it and how they get it up and running in the first place.
Let's start by going through the stages of a Ponzi Scheme, and then we'll look at some math.
Stage 1: Inception
Stage 1 of a Ponzi scheme is the inception, where the charismatic promoter creates and introduces the investment opportunity to potential investors. But what goes on behind the scenes of this stage, and how do these promoters convince people to invest in their schemes?
The art of “the pitch” is a crucial element of Stage 1. A successful Ponzi scheme promoter is someone who can talk a good game, build trust with potential investors, and make the opportunity seem too good to pass up.
One common tactic is to use personal connections and networks to create a sense of credibility around the investment opportunity. The promoter may ask friends and family to invest, knowing that their participation will make the scheme seem more legitimate to others.
Another tactic is to target specific types of investors. Promoters of Ponzi schemes often target elderly people or individuals who are new to investing and may be more susceptible to persuasion. These targets may be more likely to trust the promoter's assurances that the investment is safe and profitable.
Perhaps the most important tactic is the promise of high returns. Promoters of Ponzi schemes often promise returns that are significantly higher than what is available from legitimate investment opportunities. These returns are often guaranteed or backed by false financial statements, which create the illusion of profitability.
All of these tactics are designed to convince potential investors to hand over their money. And unfortunately, they often work. The scheme gains momentum, and more and more people begin to invest.
But as the scheme grows, it becomes more difficult to sustain. In Stage 2, we'll explore how promoters of Ponzi schemes maintain the illusion of profitability and attract even more investors, even as the scheme unravels behind the scenes.
Stage 2: Expansion
Now that the “charismatic” promoter has worked their magic and convinced potential investors to hand over their money, the scheme gains momentum. This is the second stage when more and more people begin to invest.
So, how do promoters of Ponzi schemes maintain the illusion of profitability and attract even more investors, even as the scheme unravels behind the scenes?
One key tactic used during this stage is paying off early investors. The promoter uses the capital from new investors to pay off earlier investors, creating the impression that the investment is profitable and generating high returns.
This creates a positive feedback loop, where early investors tell their friends and family about the opportunity, attracting even more investment.
Promoters of Ponzi schemes also use false financial statements to create the illusion of profitability.
These statements may show significant returns, even though the investments are not actually generating profits. In some cases, the promoter may create a fictitious accounting firm to produce these statements and add to the scheme's credibility.
Another tactic is to offer incentives to investors who bring in new investments.
This can be referral fees or higher returns for larger investments. These incentives create a sense of urgency and excitement around the investment opportunity, leading to even more investment.
All of these tactics are designed to maintain the illusion of profitability and attract even more investment. But as the scheme grows, it becomes more difficult to sustain.
In Stage 3, we'll explore how Ponzi schemes reach a critical mass of investors and begin to unravel.
Stage 3: Maturity
In Stage 3, the scheme reaches a critical mass of investors, and the promoter may begin to struggle to maintain the illusion of profitability.
At this point, the scheme matures, and the promoter may be faced with some difficult choices. They may choose to create more false reports or financial statements to continue their illusion of profitability. They can also continue to incentive existing investors to recruit more investors.
However, this is also the stage where Ponzi scheme promoters start using funds for personal expenses, making it hard to manage payments to investors.
As the scheme grows, the promoter might struggle to pay early investors while attracting new investments. It's a difficult balancing act. They must decide whether to can keep the Ponzi going or pull the rug out and disappear with everyone's money.
Whatever they decide, eventually, the scheme reaches a tipping point when there are no longer enough new investors to pay off earlier investors.
If they decide to stick it out, the scheme will begin to unravel. The promoter will delay the collapse as best they can by coming up with excuses and offering delayed payment schedules. They'll tell investors that payment processing issues are why they’re not getting paid or that they've been hacked. They'll also dodge phone calls, texts, emails, and other forms of communication.
This is when investors become suspicious and demand their returns. The scheme is approaching collapse.
One of the most famous examples of a Ponzi scheme that reached maturity and began to unravel in the case of Bernie Madoff. Madoff's Ponzi scheme had been operating for decades, and he had attracted a large number of wealthy investors. But as the scheme grew, Madoff struggled to maintain that “illusion of profitability,” and it finally collapsed in 2008.
Obviously, the consequences of participating in a Ponzi scheme can be severe. Not only can you lose all of your money, but even if you get out before the fall, the courts can come after you to pay back what's owed to late-stage investors. In Stage 4, we'll explore further how Ponzi schemes begin to collapse and the consequences for investors and perpetrators.
Stage 4: Decline
As mentioned above, the decline usually begins when new investors are no longer enough to pay off earlier investors. The promoter has tried to delay the collapse. They lie to investors, come up with excuses, and dodge all communication. In some cases, they may even leave the country.
The inevitable outcome is near.
As an investor though, the consequences can be severe. Investors may lose all of their money or a portion of their investment. They may also experience a significant emotional toll, feeling embarrassed or ashamed for being taken in by the scheme. This can lead to depression and despair, sometimes with a tragic end.
It can also lead to legal trouble.
More and more investors realize what's happening if they haven't figured it out already. That leads to a domino effect where every investor is headed for the door, all wanting their money at the same time. Of course, it's impossible for the promoter to pay everyone back.
The scheme collapses.
Having said that, the duration of a Ponzi scheme can depend on the size of the scheme and the number of investors involved. Smaller schemes may collapse more quickly because they require fewer new investors to keep them going, while larger schemes may last for years or even decades.
Other factors that can impact the duration of a Ponzi scheme include the returns promised to investors and the ability of the scheme operator to keep the illusion of profitability going. If the promised returns are modest, the scheme may collapse more quickly because it will take longer to attract enough new investors to support the returns promised to earlier investors.
But this also depends on how often investors withdraw their money, which depends on other factors like the economy's health.
In contrast, if the promised returns are extremely high, the scheme may attract new investors more quickly, allowing it to persist for longer. Also, if the scheme operator is skilled at creating the illusion of profitability, the scheme may endure longer.
However, no matter how long a Ponzi scheme lasts, it is ultimately unsustainable. The scheme will eventually collapse when there are no longer enough new investors to support the returns promised to earlier investors. This can happen suddenly and without warning or it can be a slow and gradual process.
The collapse of a Ponzi scheme can also have wider economic consequences. If the scheme is large enough, it can create a ripple effect, damaging the economy as a whole. For example, the collapse of Bernie Madoff's Ponzi scheme, as mentioned earlier, had significant consequences for the financial industry.
The perpetrators of Ponzi schemes often face significant legal consequences. In addition to the criminal charges they may face, investors may also sue them for their losses.
Stage 5: Discover and Consequences
The final stage of a Ponzi scheme is when it is discovered by authorities or investors and the consequences they face.
Legal charges may be brought against the promoter when this happens, and they could face imprisonment.
Perpetrators of Ponzi schemes may face significant legal consequences, including criminal charges and class action lawsuits. They may be charged with securities fraud, wire fraud, and other crimes related to the fraudulent scheme.
If found guilty, they may be required to pay restitution to investors and could face prison time and substantial fines.
Unfortunately, investors may also suffer as a result. While they are not generally considered liable for the actions of the scheme's operators or be held legally responsible for the scheme's losses, there are exceptions.
Under some circumstances, investors may be sued or held responsible for participating in the scheme.
For example, if an investor knowingly recruited other investors or helped promote the scheme, they may be considered a net winner and must return some or all of their profits.
This is because these investors received returns from the scheme at the expense of later investors who lost their money.
Also, if an investor knew or should have known that the investment opportunity was fraudulent, that may make them liable for their participation. This could include situations where the promised returns are unrealistically high, or the scheme operator has a history of fraudulent activity.
However, in most cases, investors “who were victims” of a Ponzi scheme are not held responsible for the operators' actions.
It's important to note that the legal ramifications of participating in a Ponzi scheme can vary depending on the specific circumstances. If you have been involved in a Ponzi scheme, seeking expert legal advice is important to understand your rights and responsibilities.
Do Ponzi Schemes Always Fail?
Yes, Ponzi schemes always fail. They are inherently unsustainable, and all Ponzi Schemes will inevitably collapse. The length of time one can continue operating depends on various factors, including the number of new investors and the amount of money being invested.
However, it's important to recognize that no matter how long a Ponzi scheme lasts, it will eventually crumble, leaving investors with significant financial losses.
But let's look at the math to demonstrate why they always fail.
Let's say a promoter creates a Ponzi scheme and convinces 10 people to invest $1,000 each, totalling $10,000.
The promoter promises 10% per month returns and therefore must pay $100 monthly to each of the 10 investors (after the first month). This is done using $1,000 from the original funds received ($10,000).
In the second month, each new investor brings one person into the scheme. As a result, 10 new investors join, each investing $1,000. There is now a total of 20 investors.
This creates a pyramid of investors that is often mistaken for a pyramid scheme. But pyramid schemes and Ponzi schemes have their own unique elements, although they are similar.
So, these 20 new investors also expect a 10% return each month on their money.
Now the scheme operator has accepted $20,000 in total funds and paid out $3,000. Let's play this out for 4 months, with each investor bringing in 1 new investor each month.
- Month 0 Payout = $0 (10 investors) with total funds collected at $10,000
- Month 1 Payout = $1,000 (20 new investors) with total funds collected at $30,000
- Month 2 Payout = $3,000 (40 new investors) with total funds collected at $70,000
- Month 3 Payout = $7,000 (80 new investors) with total funds collected at $150,000
However, the promoter must pay out 10% monthly, so the total fund value at this point is only $139,000. It's gets a bit messy depending on the join and payout dates, but we'll just say it's the first of the month for simplicty.
Using the example above, 80 new investors join in month 3 so the total funds collected add up to $150,000.
But the promoter must pay out $7,000 that month to the 70 investors already in the fund from previous months (10 + 20 + 40).
He or she had also paid out in previous months to those earlier investors. $1,000 in month 1 to those who joined in the previous month, and $3,000 in month two because at that point, there were 30 investors.
So the total payments made at that point add up to $11,000 (1,000 + $3,000 + $7,000). That leaves $139,000 in the fund.
I'll add a table below so you can better visualize what's going on…
On the surface, everything seems great. There are no problems as long as two things happen.
- Investors keep their money in the fund.
- Enough new investors keep joining.
Of course, these are hypothetical numbers, and it's unlikely any Ponzi scheme would have perfectly round numbers. Also, new members come in at various times during the month…
… but again, for the sake of simplicity, let's continue on this schedule.
Let's say new investor recruitment slows considerably. Only 40 new investors join the scheme in month 4.
Another $40,000 is added to the fund, but the 10% payout at the end of the month (or the beginning of the next month) was $19,000 because, at that point, 190 investors had joined the scheme.
So the new investments were smaller than the previous month…
… but the payments were larger.
In month 5 recruitment slows even further. Another 20 people join, adding $20,000 in new investment. But the 10% return payments at the end of that month (or the beginning of month 6) now add up to $21,000.
At this point, the promoter's outgoing expenses exceed new investments, and this is where it gets dicey.
In the real world, the investors don't notice this because they are rolling their 10% over rather than pulling it out. But the promoter must make sure investors remain. If they start cashing out, there won't be enough money to pay everyone.
In month 6, the total funds available (after the 10% promised returns are accounted for) are only $145,000.
But if everyone withdrew their money (at the end of month 6), the total amount needed to pay everyone would be $210,000 (principle investment) + $21,000 (return payments for that month) for a total of $231,000.
That's an $88,000 shortfall.
Now let's say the investors are getting a little suspicious. They keep their money invested but are not confident enough to recommend it to others.
As a result, no new members join in month 7.
So new money has dried up, but the promoter is still on the hook for $22,000 in return payments. If he or she doesn't pay, word gets out and everyone requests a withdrawal. The scheme collapses.
The following table shows how this plays out…
| Month | # of Investors | Total New Investment | Monthly Return Payments | Total Funds Value | Funds Available | Shortfall |
|---|---|---|---|---|---|---|
| 0 | 10 | $10,000 | $0 | $10,000 | $10,000 | $0 |
| 1 | 20 | $20,000 | $1,000 | $30,000 | $29,000 | -$1,000 |
| 2 | 40 | $40,000 | $3,000 | $70,000 | $66,000 | -$4,000 |
| 3 | 80 | $80,000 | $7,000 | $150,000 | $139,000 | -$11,000 |
| 4 | 40 | $40,000 | $15,000 | $190,000 | $164,000 | -$26,000 |
| 5 | 20 | $20,000 | $19,000 | $210,000 | $165,000 | -$45,000 |
| 6 | 10 | $10,000 | $21,000 | $220,000 | $154,000 | -$66,000 |
| 7 | 0 | $0 | $22,000 | $220,000 | $132,000 | -$88,000 |
| 8 | 0 | $0 | $22,000 | $220,000 | $110,000 | -$110,000 |
| 9 | 0 | $0 | $22,000 | $220,000 | $88,000 | -$132,000 |
| 10 | 0 | $0 | $22,000 | $220,000 | $66,000 | -$154,000 |
| 11 | 0 | $0 | $22,000 | $220,000 | $44,000 | -$176,000 |
| 12 | 0 | $0 | $22,000 | $220,000 | $22,000 | -$198,000 |
| 13 | 0 | $0 | $22,000 | $220,000 | $0 | -$220,000 |
As you can see, if the scheme operator paid the 10% monthly, by month 13, the funds available reach zero. They can't pay back investors their principle investment, and they can't make the interest payment either.
Most likely, they would have been scrambling for new investments over the last few months with little success.
If the existing investors hadn't run for the door yet, they would now because the operator could no longer make their payments. They'd know for certain at this point they were part of a Ponzi scheme.
Again, in the real world, this would play out differently. The scheme operator would probably be skimming money, further reducing the available funds. They'd also plan their escape sooner so that they still had money in the fund to escape with.
This example demonstrates a small Ponzi scheme, but some can get into the billions. Bernie Madoff's scheme defrauded investors of roughly $65 billion dollars.
The Consequences of Participating in Ponzi Schemes
We discussed the consequences earlier when discussing the life cycle of a Ponzi scheme, but it doesn't hurt to hammer this point home.
First, it's important to recognize that Ponzi schemes are illegal. Promoters of Ponzi schemes can face criminal charges, including fraud and securities violations. They can be fined, imprisoned, and required to pay restitution to victims of the scheme.
In many cases, the promoter may have to forfeit assets obtained through the scheme, such as cars, homes, and other property.
For participants in a Ponzi scheme, the consequences can be devastating.
Investors may lose significant amounts of money and, in many cases, their life savings. The promised returns that were once so alluring can quickly turn into significant financial losses, leaving investors with little or no recourse for recovery.
The emotional toll of participating in a Ponzi scheme can be just as significant as the financial losses.
Investors may feel a sense of shame or embarrassment for falling victim to the scheme, and they may experience anxiety, stress, and depression as a result. And it can be challenging, if not impossible, to rebuild one's financial security, not to mention the emotional well-being after being scammed in a Ponzi scheme.
It goes without saying that participating in a Ponzi scheme can have severe and long-lasting consequences for both the promoter and the participants. It's can't be overstated that recognizing the warning signs of a fraudulent investment opportunity can save you from financial and emotional tragedy.
It's even worse if you have people who depend on you.
Always seek expert advice before investing. Do proper research. Be wary of unrealistic returns and investment projections. Even the best investors in the world have “only” averaged between 20 – 30 percent.
I say “only” sarcastically. 20 – 30 percent is an extraordinarily high average annual return. It only seems small compared to the ridiculous rate or returns promised by Ponzi schemes.
In the example I gave above, I used what seems like a relatively small 10% monthly return.
However, the effective annual rate (APY) of 10% monthly is actually 213.8%… or ten times higher than what you could expect if you gave your money to the world’s best investors.
So if someone promises you these kinds of returns, it’s an almost certain sign of a Ponzi scheme. One exception would be if you were investing in something like a start-up, for example, but that’s an entirely different conversation and an entirely different set of skills.
Another exception could be real estate.
But both of those types of investments come with different levels of uncertainty and risk.
Ultimately, if something seems too good to be true, there’s a good chance that it is. That doesn't mean you shouldn’t investigate it, but be diligent. It’s your hard money these scammers and schemers are after.
