What is a Ponzi Scheme and How to Avoid It

There are a seemingly never ending supply of scams and ripoffs designed to take your hard earned money away from you. Some con artists use simple methods to extract money from their victims, while others use a more sophisticated style. The Ponzi scheme can fall into both categories; both types will end up with you losing your hard earned cash. Let’s look at what a pyramid scheme is and how to avoid one.

Photo by Abode of Chaos via Flickr

What is a Ponzi Scheme?

A Ponzi scheme is a variation of a pyramid scheme. It is designed so that one person at the top of “pyramid” nets all the profits from the scam. Some of the victims below the top can actually profit off of the scheme for a while, but in the end everything comes crashing down.

One of the most famous Ponzi schemes of late is the one run by Bernie Madoff. He promised high roller investors incredibly high and consistent returns on their investments. Those with a knowledge of finance know that high returns, year in and year out, is an impossible achievement. Yet Madoff continued to roll out consistent returns to his victims for many years… until it all came tumbling down.

How does a Ponzi Scheme Work?

The catch of a Ponzi scheme is that the scam has just enough truth in it to be believable. Most schemes involve promising a designated return on investment, one that is higher than industry norms and proposed to have very little (if any) risk. Every legitimate investment brokerage out there says “past results are not indicative of future returns” or something similar for a good reason. Predicting consistent, high returns is impossible.

The scheme works in the following manner:

  • Scammer promises high returns, say 5% per month, with consistent payouts.
  • Scammer convinces first few victims to “invest” with him. These victims are right under the peak of the pyramid and will help lay its foundation.
  • At the end of the first month, the top of the pyramid pays out its first 5% “return” to the victims. This money is provided through their initial investment. (The scammer could pay out 20 months worth of 5% “returns” before running out of cash.)
  • This goes on for a few months and the victims believe they are in on a great deal. They tell more people to send money in. This is the next level of the pyramid.
  • The new (and old) investors are so amazed at the results that they convince more people to pour more money in the pot. They usually contribute more money themselves.

This goes on and on until their are hundreds or thousands of victims that have given hundreds of thousands or even millions of dollars to the scammer. Everything is still going well — those 5% payments are still coming back in.

But that’s when things hit a wall. The scammer runs off with a huge chunk of the investment and blows it on homes, travel, cars, etc. Suddenly those 5% monthly payments stop coming in, and people start asking questions and demanding documentation. Of course by then it is too late. The money is gone, and there is no documentation.

How to Avoid Ponzi Schemes

Avoiding these schemes is theoretically pretty easy. Remember this rule of thumb: If it sounds too good to be true, it probably is. Earning 5% per month is over 60% per year when you factor in compound growth. When is the last time you were able to get that kind of return consistently and without risk? It is a financial impossibility.

Aside from that, do your due diligence on any investment you consider. Ask questions about how the money is being invested, what SEC filing documents can be provided, and for a comparison of risk compared to other investments. If you get shady answers like “We can’t show you how we make money or what it will be invested in”… run away.

Additionally, instead of aiming for returns of 25%, 50%, or 100% per year (as is common with these scams), accept being average by only investing in low cost index mutual funds and ETFs. You will get the average return of the market. This means you won’t beat the market, but it won’t beat you and you’ll know your money is legitimately invested.

Have you or someone you know fallen victim to a Ponzi scheme? How much money was lost and what was the scam?

About the Author

By , on Sep 2, 2011
Kevin Mulligan
Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He's building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, and many others.

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Leave Your Comment (One Comment)

  1. Vincent says:

    There are no guarantees in life except death and taxes! If your financial manager is promising you a specific return, he is most likely violating his fiduciary duty to you as the client. Most of the good wealth management teams will tell you up front that there are no guarantees in the market.

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