What is a Ponzi Scheme?

Imagine you handed over your life savings to an investment manager you trusted, who promised you that his investment plan would earn you extremely high returns, above anything you had heard. Now imagine one day you woke up and found out that you had lost it all! That's basically how a Ponzi scheme starts and ends, but what exactly are the warning signs to look for and identify possible Ponzi schemes?

A Ponzi scheme is a form of investment fraud that involves payment of alleged or reputed "returns on investment" to investors paid from funds put in by new investors. The Ponzi scheme got its name from Charles Ponzi who became known for using this scheme in the 1920's. Charles Ponzi gave investors 50% interest on short-term investments with funds from new investors. Ponzi, however, was not the first to use the scheme, but his acts took in so much money that he was the first to make it famous.

The Ponzi scheme was eventually made illegal, yet this "rob-Peter-to-pay-Paul" form of a pyramid scheme still continues. The largest Ponzi scheme in history is, of course, the Bernie Madoff Ponzi scheme. The actual losses to investors from the Madoff scheme is estimated at around $18 billion.

In short, Ponzi schemes purport to generate high returns with no risk. Instead of engaging in any legal investment action, Ponzi fraudsters focus on attracting new money to make assured payments to existing investors and to use for their personal expenses.

Here are some of the warning signs to look for to identify possible Ponzi schemes:

  1. Rule of Thumb to avoid Ponzi schemes: If it seems to good to be true, it is. If any broker or advisor assures you that you will receive returns that are far above the expected and reasonable rate expected in the investment market, don't let greed get the best of you.

  2. Avoid investments if you can't get complete information or you don't understand their strategies; it is good rule of thumb. You should know what your money is invested in and where your earnings are coming from.

  3. If you have difficulty receiving your investment or don't receive a payment, be suspicious. As Ponzi scheme organizers may encourage investor to reinvest their "profits" and take a small payoffs instead, in return for the promise of higher returns.

  4. Ponzi schemers may also make the investment seem more legitimate by making it appear to be an "exclusive" club. Madoff, for example, would turn people down and also had a high minimum investment amount. This strategy had people begging him to "let them in the club." There is no magic exclusive club that earns higher returns than everybody else, so don't fall for it.

  5. Most Ponzi scheme organizers will send investors periodic reports with less-than-normal information on it. This is a huge red flag. Honest investment firms will provide detailed and professionally prepared reports on a monthly or quarterly basis or both. The reports should include clear details about any changes in your funds, whether you have lost or made money, and it should tell you where your funds are invested. Ponzi schemes perpetuate since victims generally trust the Ponzi organizer enough to overlook the lack of documents.

In sum, if you stick with the Rule of Thumb: "If it sounds too good to be true, it is," you should never fall victim to a Ponzi scheme. Use your common sense and don't let your emotions overrun reasonable thought. If someone promises guaranteed returns over the market rate, it is just not feasible. Markets fluctuate and no honest broker or advisor can honestly guarantee high returns and low risk.