What is a Ponzi scheme?

Lisa Smith, BA (Hons), CeFA

A Ponzi scheme is a type of elaborate fraud, named after its first notorious perpetrator, Charles Ponzi, who operated in the 1920s in the United States.

The fraudster devises an investment plan which promises high returns to its participants. The reality is that the “proceeds” they receive are their original stakes. Ponzi schemes can be sustained for many years, especially when they are dressed up with official sounding marketing materials.

Ponzi schemes inevitably collapse – when the schemes fail to recruit new investors the money eventually dries up. Alternatively, in a depressed financial environment a run on the scheme from investors asking for their money back can bring the thing to its knees.

The biggest such scheme was run by Bernie Madoff, who was a well-known and well respected figure who had held senior positions in the New York financial scene. His victims include charities and his own friends, and the success of his scheme in recruiting such high calibre investors is down to his personal credibility. His schemes also made some trades, although not nearly enough to realise the returns that he promised.

Why do people fall for such scams?

Financial scams may seem obvious with the benefit of 360 degree hindsight. During the decade or so when the scam was taking place, there were a few journalists and whistle blowers who had always claimed that something was afoot with Madoff, but they were dismissed as paranoid conspiracy theorists.

Human nature is such that we trust what is put in front of us – especially when what is put in front of us is a promise to give us a 10% per annum return! There is also the issue of the company you keep. If the friends and associates that you trust have also decided to invest in a scheme, their decision somehow endorses your own investment.

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