What Is A Ponzi Scheme (Explained: All You Need To Know)

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What Is Ponzi Scheme

A Ponzi scheme refers to a type of investment fraud where the Ponzi scheme organizers collect money from new investors to pay old investors.

The idea is for the organizer to promise new investors that they can generate high returns if they invest some money.

When the new investor decides to invest, the Ponzi scheme organizers will not invest the money but will rather use that money to pay fake “returns” to the existing investors.

Seeing actual returns paid to them, the existing investors may potentially be tempted to invest more money hoping to collect high returns and the same cycle continues.

For a Ponzi scheme to work, the fraudsters will need to ensure that they generate a steady stream of cash flow by attracting new investors.

This is crucial as they need money from new investors to pay out fake dividends or interest payments to existing investors.

The moment the fraudsters are no longer able to collect money from new investors to pay old investors, the scheme starts to fail.

Keep reading as I will further break down the Ponzi scheme and tell you how it works.

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Ponzi Scheme Origin

The Ponzi Scheme is named after Charles Ponzi who was a con artist in the 1920s promising investors a high return within a short period of time by investing in international mail coupons.

Charles Ponzi then used the money invested by unsuspecting investors to pay fake returns to earlier investors.

Investors who are attracted by the idea of generating high returns in a short period of time without taking much risk are exposed to being duped by Ponzi scheme organizers.

The promise of high returns and little to no risk can be tempting for many investors.

Charles Ponzi originally started his scheme based on the legitimate arbitrage of international reply coupons for postage stamps.

However, seeing that he was able to attract a lot of investors, he started using the investors’ money to pay earlier investors and himself.

His “success” generated significant press coverage making him a recognizable figure in the investment community.

However, after his scheme collapsed, this type of investment fraud was eventually named after him.

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How Does A Ponzi Scheme Work

A Ponzi scheme is a method where a fraudster will ask investors to invest money in an investment vehicle that has the potential to generate high returns.

When prompted about the nature of the investment, the scammers will remain vague by referring to “complex strategies”, “hedge futures trading”, or “offshore investments”.

Ponzi scammers tend to have a higher rate of success with individuals that do not have much investment knowledge or take advantage of their gullibility.

As the scammer attracts a new investor, the new investor’s money will be used to pay “fake” returns to the old investors leading them to believe that they are generating money on their investment.

To make the scheme more credible, the Ponzi scheme operators will send the investor an account statement showing how much they invested and how much they earned so far.

Ponzi scammers will also attempt to keep their investors “invested” so they do not cash out their principal as this will lead to a cash drain for the scammers.

To lock investors in, the scammers will promise investors a higher return provided their investment is locked for a certain period of time.

For so long as the scammers are able to attract new investors to pay returns to old investors, the scheme can work undetected.

However, when the operators are no longer able to generate the needed cash flow to pay the fake returns to the old investors, eventually the scheme will be detected.

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How To Avoid Ponzi Schemes

Everyone should take precautions to avoid falling into the trap of a Ponzi scheme.

It goes without saying that when you invest your money, you should do your due diligence first.

Make sure that you are giving your money to someone who is trustworthy, works in a legitimate firm or investment company, make sure you get relevant information on the risk and reward, and so on.

Here are some red flags that can help you detect a Ponzi scheme so you can avoid it.

The first red flag is that you are promised a high return without having to take much risk.

In some cases, you are even guaranteed a return on an investment opportunity, which is highly unrealistic.

Another characteristic of Ponzi schemes is that you are generating consistent positive returns no matter the market condition.

Also, when you ask the fraudsters about their investment strategy, they will tell you that it’s highly complex or must be kept a secret so others cannot copy the same strategy.

You should also assess whether or not your investment advisor is duly licensed to provide investment advice.

If the investment professional is not licensed, it should be a major red flag.

Other ways you can detect a Ponzi scheme is that the investments tend to be unregistered investments, you may have errors on your account statements, and you may not be able to cash out your investment easily.

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Ponzi Scheme Example

Let’s look at an example of a Ponzi scheme to better understand how it works.

Let’s assume that Mark is a Ponzi scheme operator offering his friend Steve a return of 15% on an investment provided Steve invests $10,000.

Steve is convinced and pays Mark $10,000 hoping to earn a 15% return in the course of the year.

In parallel, Mark convinces Mary to invest $20,000 to earn a 15% return as well.

So now, Mark has collected a total of $30,000 from Steve and Mary.

Now, if Mark can take $11,500 from his $30,000 stash to pay Steve’s principal and interest, Steve will be convinced that the investment strategy works. 

Steve will be encouraged to reinvest his money again so Mark gets back the $11,500.

Mark’s objective is to continue bringing in new investors so he can redistribute the money he receives from one investor to another leading them to believe they are making money.

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Takeaways 

So there you have it folks!

What is a Ponzi scheme?

In a nutshell, a Ponzi scheme refers to an investment scam where the scammer promises investors high returns with little to no risk.

The idea is “to rob Peter to pay Paul”.

The scammers will divert a new investor’s money to pay returns to an old one.

According to the US Securities and Exchange Commission, some “red flags” to detect Ponzi schemes are the promise of high returns with little risk, consistent positive returns, unregistered investments, unlicensed investment advisors, vague investment strategies, and paperwork errors.

All investors should make sure that they have properly verified that their investment professional is duly licensed, is selling legitimate investment instruments, and understands exactly the investment strategy.

To avoid falling into the trap of a Ponzi scheme, you should make sure you do not work with pushy sellers, don’t take investment advice through cold calls or unsolicited emails, trace the investment and strategy, and ask a lot of questions.

Now that you know what a Ponzi scheme is and how it works, good luck with your investment.

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