A Ponzi scheme is an investment fraud in which the organizer promises investors large, quick and certain profits, which are paid out not from the actual earnings of a business, but from money brought in by newer investors.
How does a Ponzi scheme work?
The mechanism of a Ponzi scheme is relatively simple, but extremely effective at conning people:
- Exaggerated promises: an individual or company lures investors by promising unusually high returns with little or no risk. These promises are often far better than those offered by legitimate investments in the market.
- Secrecy and complexity: Often, the scheme is presented as an exclusive investment opportunity or using a secret, highly complex and difficult to understand strategy, precisely to discourage questions and create an air of mystery and ingenuity.
- Paying out to early investors: In order to gain trust and attract new funds, the organizer of the scheme uses part of the money invested by newcomers to pay out the promised profits to older investors. This payment makes the first investors believe that the business is legitimate and profitable.
- Word-of-mouth effect: Seeing that the first investors receive the money and the promised “profits”, they enthusiastically talk about their “success” to friends and family, thus attracting a steady stream of new victims into the scheme. This is the fuel that keeps the scheme alive.
- Lack of real economic activity: The essence of a Ponzi scheme is that there is no real economic activity or legitimate product/service that generates the promised profits. Money is simply moved from one investor to another. The organizer, of course, keeps a considerable part of the money for his lifestyle.
- The inevitable collapse: A Ponzi scheme is doomed to fail. It depends on a steady and increasing flow of new investors. When that flow slows or stops (because there aren’t enough new people to attract), or when a large number of investors ask to withdraw their money at the same time, the scheme can no longer make the promised payouts and collapses. Then most (most recent) investors lose all or almost all the money they invested.
Why is it called a Ponzi Scheme?
The name comes from Charles Ponzi, an Italian immigrant who, in the 1920s, ran one of the most famous such schemes in the United States. He promised huge profits from buying and selling international postal coupons, but in reality, he paid old investors with money brought in by new ones.
The hallmarks of a Ponzi scheme (so-called “red flags”):
- Incredibly high and guaranteed returns: any investment with zero risk and huge returns is almost certainly a fraud. Legitimate investments always involve some degree of risk, and high returns come with risks to match.
- Unusually consistent returns: Markets fluctuate. An investment that reports consistent returns month after month, regardless of economic conditions, is suspect.
- Pressure to reinvest: Organizers are constantly urging you not to withdraw your money but to reinvest it for even higher returns.
- Lack of transparency and vague information: You don’t get clear documentation, you don’t understand exactly how the profits are generated, and the organizer avoids answering detailed questions.
- Difficulty withdrawing money: If you encounter obstacles or delays when trying to withdraw your investment, this is a major red flag.
- The need to recruit new investors: Although Ponzi schemes are different from pyramid schemes (which rely directly on recruitment), some Ponzi schemes may offer bonuses for bringing in new investors to ensure a steady flow of money.
- Unauthorized salespeople or unregistered investments: Most legitimate investments are regulated and registered with the financial authorities. If the person offering you the investment is not licensed or the investment is not registered, be extremely cautious.
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