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Ponzi Scheme

A fraudulent investment program that involves using payment collected from new investors to pay off the earlier investors

What is a Ponzi Scheme?

A Ponzi scheme is considered a fraudulent investment program. It involves using payment collected from new investors to pay off the earlier investors. The organizers of Ponzi schemes usually promise to invest the money they collect to generate supernormal profits with little to no risk.

 

Ponzi Scheme

 

However, in the real sense, the fraudsters don’t really plan to invest the money. Their intention is to pay off the earliest investors to make the scheme look believable. As such, a Ponzi scheme requires a constant flow of funds to sustain itself. When the organizers can no longer recruit more members or when a vast proportion of the existing investors decide to cash out, the scheme tumbles.

 

Breaking Down Ponzi Schemes

A Ponzi scheme is simply a type of investment where investors are promised substantial returns. Companies that participate in Ponzi schemes focus all of their attention to luring new clients. Once the new entrants invest, the money is collected and used to pay the original investors as “returns.”

However, a Ponzi scheme is not the same as a pyramid scheme. With a Ponzi scheme, investors are made to believe that they are earning returns from the little they invest. In contrast, participants in a pyramid scheme are aware that the only way they can make profits is by recruiting more people to the scheme. To a great extent, Ponzi schemes are investment tricks.

 

Red Flags of Ponzi Schemes

Most Ponzi schemes come with some common attributes such as:

 

1. Promise of high returns with minimal risk

In the real world, every investment one makes carries with it some degree of risk. In fact, investments that offer high returns carry more risk. So, if someone offers an investment with high returns and few risks, it is likely to be a too-good-to-be-true deal. Chances are the investor won’t get any returns.

 

2. Overly consistent returns

Investments experience fluctuations all the time. For example, if one invests in the shares of a given company, there are times when the share price will increase, and other times, it will decrease. That said, investors should always be skeptical of investments that generate high returns consistently regardless of the fluctuating market conditions.

 

3. Unregistered investments

Before rushing to invest in a scheme, it’s important to confirm whether the investment company is registered with U.S. Securities and Exchange Commission (SEC) or state regulators. If it’s registered, then an investor can access information regarding the company to determine whether it’s legitimate.

 

4. Unlicensed sellers

According to federal and state law, one should possess a specific license or be registered with a regulating body. Most Ponzi schemes deal with unlicensed individuals and companies.

 

5. Secretive, sophisticated strategies

One should avoid investments that consist of procedures that are too complex to understand.

 

History of the Ponzi Scheme

The scheme got its name from one Charles Ponzi, a fraudster who duped thousands of investors in 1919.

Ponzi promised a 50% return within three months on profits earned from international reply coupons. Back in the day, the postal service offered international reply coupons, which enabled a sender to pre-purchase postage and incorporate it in their correspondence. The recipient would then exchange the coupon for a priority airmail postage stamp at their home post office.

Due to the fluctuations in postage prices, it wasn’t unusual to find that stamps were pricier in one country than another. Ponzi saw an opportunity in the practice and decided to hire agents to buy cheap international reply coupons on his behalf then send them to him. He exchanged the coupons for stamps, which were more expensive than what the coupon was originally bought for. The stamps were then sold at a higher price to make a profit. The trade is known as arbitrage, and it’s not illegal.

However, at some point, Ponzi became greedy. Under the Securities Exchange Company, he invited people to invest in the company, promising 50% within 45 days and 100% within 90 days. Given his success in the postage stamp scheme, no one doubted his intentions. Unfortunately, Ponzi never really invested the money, he just plowed it back into the scheme by paying off some of the investors. The scheme went on until 1920 when the Securities Exchange Company was investigated.

 

How to Protect Yourself from Ponzi Schemes

In the same way that an investor researches a company whose stock he’s about to purchase, an individual should investigate anyone who helps him manage his finances. The easiest way to go about it is to contact the SEC and ask if their accountants are currently conducting open investigations (or investigated prior cases of fraud).

Also, before investing in any scheme, one should ask for the company’s financial records to verify whether they are legit.

 

Key Takeaways

A Ponzi scheme is simply an illegal investment. Named after Charles Ponzi, who was a fraudster in the 1920s, the scheme promises consistent and high returns, yet it carries very little risk. Although such a scheme can work in the short term, it runs out of money eventually. Therefore, investors should always be skeptical of investments that sound too good to be true.

 

More Resources

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Cash Larceny
  • Investing: A Beginner’s Guide
  • Threats to Auditor Independence
  • Top Accounting Scandals

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