What is a Ponzi Scheme, and how can you avoid getting caught in one?

Bernard Madoff is a household name. He bilked billions, some estimates say $65 billion, from duped investors across the country. He’s about to go to jail. Still few people, if any, know how he tricked investors, skated by the Securities and Exchange Commission and operated the largest investment scam in history.

Charles Ponzi, the scheme’s namesake, did not invent the plan. His success in the early 1900s brought him copious wealth and widespread fame, until he became notorious. Madoff’s operation is an even more successful version of Ponzi’s grand schemes.

A Ponzi scheme sounds like such a simple word for a complex operation. However, it’s really a simple word for a simple scheme that should have everyone looking to get rich quick questioning all their investments with a skeptical eye.

Ponzi schemes are confidence games. They rely on a confident salesman guaranteeing something that sounds promising to the untrained ear, but too good to be true to anyone that has any financial knowledge.

Investors, often elderly, are lured into the scam by complex market terminology that makes no sense to them. They trust the person knows what they’re talking about and he’s not lying. They trust millions in someone they hardly know.

Ponzi schemes rely on one thing: new investors. The scheme promises large payouts, short-term gains and ultimately unrealistic success. Investors pay into a Ponzi scheme on the premise their money will be invested through the shrewd practices of exceptional analysts with computers full of data prepared to shoot out the $60 million question: where should we invest? The operator sometimes sends out fake account statements showing large stock gains, but they are just a distraction to keep people’s money in the game, giving the idea they are earning money.

Yet that is all just a hoax. The investors only get paid when new investors join. Those new investors pay the original investors and keep the charade of a successful investment plan going until, of course, investors run out or too many investors ask for repayment.

This is what happened to Madoff in 2008. Too many investors suddenly withdrew their money from the scheme which Madoff operated since the 1990s. The economic recession led to weary investors across the board, so finding new investors to pay off the original investors was not possible. He was exposed for having spent the money he was supposed to invest and lying to investors.

Ponzi schemes can survive for a long period of time, especially when the investors are tricked into re-investing their money. They see what great payouts they initially received, so if they re-invest their money, then they can make even more. Therefore the money they actually made is never seen. The money and the statements are illusions to the keep the scheme’s operator living a lavish lifestyle of luxurious wealth with an ability to please other investors down the line.

Ponzi schemes always fail because eventually people want their payout, which does not exist. Eventually, the investors or authorities realize what is going on and close the operation. Eventually, the ringleader gets too greedy and the money isn’t there to keep investors calm.

The old adage, if it seems too good to be true, couldn’t be truer than with a Ponzi scheme. Always ask questions and seek a second opinion before entrusting your financial future to one entity.

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