What is a Ponzi Scheme?
A Ponzi scheme is a fake investment scam that promises investors high rates of return with minimal risk. The scheme deceives its victims by giving off the impression that profits generated are derived from product sales as opposed to the reality that new investors are the real source of the funds.
A typical Ponzi scheme is able to create the illusion of a long-term and profitable business as long as new investors continue contributing new funds to the scheme and as long as the majority of the investors do not request to cash out.
Charles Ponzi, where the name derives, was involved in a large deception in the United States in the 1920 and became infamous as a result of the large fortune that he accrued. Ponzi’s innovative scheme was based on a legitimate hedge investment of international reply coupons for postage stamps, however, soon after, he started diverting new investment funds to earlier investors, including himself.
Contrary to previous, similar schemes, Charles Ponzi gained significant publicity within the United States and internationally while the scheme was being orchestrated and after its demise. The notoriety gained resulted in this type of fraud being named after him.
Eventually, Ponzi schemes and pyramid schemes tend to collapse on their own weight once the wave of new investors disappears and there is not enough money to be paid out.
How do Ponzi Schemes Work?
Ponzi schemes essentially require an initial investment and guarantee investors above-average returns for their contributions. Advertising and marketing of such schemes usually involves vague language such as “hedge fund trading”, “high yield investment trading” and “offshore investment opportunities” to outline their projected income strategy. Promoters of a particular scheme will often target new or naive investors that demonstrate poor investor knowledge or competence. It is also common to conceal secret investment strategies in order to avoid handing out too much information about the scheme.
As previously discussed, the fundamental principle behind a Ponzi scheme is to compensate initial participants in a scheme at the expense of new investors. It begins with the promoter of the scheme paying higher returns in order to attract new investors and tempt current investors to invest more money. When additional investors join the scheme, it creates a knock-on effect. A return is paid out to initial stakeholders from new investor funds, as opposed to the so-called “guaranteed” profits.
High returns will invariably encourage investors to hold their funds in a scheme. This assists the conspirator who, in turn, does not need to schedule cash payouts.All that needs to be done is for the conspirator to consistently send out statements of earnings, which maintains the investments integrity. Of course, investors often find it difficult to withdraw funds from such an investment scheme.
Operators of Ponzi schemes minimize withdrawals by offering incentives to investors such as higher returns in exchange for extended periods of time where invested funds need to remain in the account. Investor’s requests to withdraw a portion of the funds are generally swiftly attended to to help keep the illusion that the fund is financially secure.
It is possible for legitimate investment schemes to rapidly transform into a Ponzi scheme. If a particular fund unexpectedly loses a substantial amount of money or fails to meet financial expectations, management might decide to falsify earnings or produce fraudulent audit reports to keep investors interested. The fund in this particular case could then quickly devolve to what many would consider a Ponzi scheme.
Identifying a Ponzi Scheme
Ponzi schemes generally share common characteristics. Keep a close eye out for the following warning signs so you don’t get caught out:
- Unusually high return with little to no risk. All investments carry a certain degree of risk and investments that yield high returns, typically require a higher degree of risk. Any suggestion of a guaranteed investment opportunity should raise a red flag.
- Consistent returns. Investment, by nature, tends to fluctuate over time. Investments that continuously report positive returns despite market trends should be treated with caution.
- Unregistered investment platforms. Financial registration is important as it provides investors with access to information pertaining to the company’s owners, management, corporate structure, products, services and financial records. Ponzi schemes will generally include investments that are not registered with the Security Exchange Commission or state regulators.
- Unlicensed investment platforms. Financial individuals and businesses require licensing and registration from well known and trusted financial regulatory bodies. Those operating without the required financial licence are recommended to stay far away from.
- Concealed, secretive strategies. If you do not understand a particular investment and cannot gather the information you require, it’s time to move on.
- Reporting Issues. Account statement miscalculations and errors could indicate that not everything is above board.
- Difficulty receiving payments. If you do not receive a payment or have difficulty cashing out, it’s time to start asking a few questions.