Trillionaire Term of the Day - February 9, 2009 - Ponzi Schemes

Ponzi Schemes

Ponzi Schemes are a type of illegal pyramid scheme that basically take money from new investors to pay off earlier investors until the whole scheme collapses.  The fraudulent investing scam promises high rates of return at little risk, and works on the “rob peter to pay paul” principle.  The scam actually works if you are an early investor and new investors continue to be duped into joining the pyramid scheme.  The problem with the scheme is that eventually there are not enough new investors coming in to produce enough money for the earlier investors.  At this point, the whole scheme unravels and the people that came into the scheme late lose everything. 

Let’s do an example of a Ponzi Scheme with 4 investors (Investor A, B, C, and D), and me as the head of the whole illegal operation.  I go to Investors A, B, and C and tell them, “I promise you will each make a 30% rate of return on your investments if you each invest $1,000 with me.  So, at this point, I owe Investors A, B, and C their $1,000 principle plus $300 worth of returns each.  I know I can’t possibly make $900 ($300 in returns X 3 investors) to pay them their promised returns by doing anything legal, so I go to investor D and tell him the same thing I told the previous three investors.  I tell investor D, “I promise you will make a 30% rate of return on your investment if you invest $1,000 with me.” So, I use Investor D’s $1,000 investment to pay off the $900 in returns that I owed to Investors A, B, and C.  Now, in order to continue paying Investors A, B, and C their 30% returns every year, and now also Investor D’s 30% return, I have to keep on bringing new investors into my Ponzi Scheme to pay them their promised returns. 

As you can tell from the example, the only way that this system can continue to work is if the head of the scheme consistently brings in new investors to pay off the earlier investors.  Also, it is clear that the early investors can earn a lot of money through Ponzi Schemes, and later investors can be ruined.  In the previous example, Investors A, B, and C all got their 30% returns from Investor D’s initial investment, so they are happy.  But, let’s say that I could not find another investor to join my Ponzi Scheme after Investor D.  In this case, Investor D would end up with only $100 left to his name, as $900 of his initial $1,000 investment went to paying the 30% returns promised to Investors A, B, and C.   

This illegal practice is named after Charles Ponzi, who cheated thousands of people back in the 1920s with a fraudulent postage stamp scheme.  Ponzi Schemes are unfortunately still used today to swindle investors, and as many of you know, Bernie Madoff was recently arrested for orchestrating a $50 billion Ponzi Scheme.  Ponzi Schemes are extremely illegal, but they are definitely interesting to think about.

Don’t get any crazy ideas.

 

Niki Pezeshki

College Trillionaire