What Is a Ponzi Scheme? - SmartAsset

A Ponzi scheme is a kind of investment scam in which investors of longer standing are paid with the buy-in contributions of newer investors. To avoid collapse, a Ponzi scheme must secure a continual supply of new investors. When a Ponzi scheme is exposed or otherwise comes to an end investors face disastrous consequences. The most catastrophic example of a Ponzi scheme – and the largest financial fraud in U.S. history – is the one perpetrated by Bernie Madoff, a once-respected Wall Street leader who swindled some 4,800 clients out of nearly $65 billion.

History of the Ponzi Scheme

The term Ponzi scheme arose from the life of Charles Ponzi, who between 1918 and 1920 started an investment scam that at first was based on arbitrage. He would obtain International Reply Coupons from Italy, redeem them for U.S. stamps and then exchange the stamps for money, earning a profit because the postage was more valuable in the U.S. than in Italy. He promised investors in this scheme that he could scale his postal operations and double their money. When they agreed, he took their cash investments and got rich. He made outlandish promises to newer investors, too, paying the older investors with the money from the new investors. A 50% return in 90 days became his trademark promise.

As more investors gave Ponzi their money, the postal arbitrage ended and the Ponzi scheme became the whole business. There was no underlying value or profit, just the paying of older investors with money from new investors. But people flocked to Ponzi’s promises of high returns, putting their life savings into the scheme. Rather than taking their profit money and getting out, Ponzi’s victims often reinvested, exposing them to the scheme’s risks anew.

Eventually, Ponzi’s millions and his lightning-fast, double-digit returns started to raise some eyebrows. Boston Post investigators looked into Ponzi’s business and made their suspicions public. Financier Charles Barron figured out that the postal arbitrage couldn’t possibly be generating Ponzi’s returns and told the press he thought that such large-scale arbitrage would be immoral even if it were feasible.

Ponzi’s Securities Exchange Company suffered the equivalent of a bank run as a result. At first, things seemed to stabilize, but then the Massachusetts U.S. Attorney stepped up investigations into Ponzi, and Ponzi’s own publicity agent revealed the scheme in the Boston Post. Ponzi was prosecuted and jailed for mail fraud. When later investment schemes replicated the Ponzi playbook they were called Ponzi schemes.

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The Modern Ponzi Scheme

Many Americans learned what a Ponzi scheme was in 2008, when Bernie Madoff’s Ponzi scheme, which defrauded investors out of $64.8 billion, came to light. Madoff, a former non-executive chairman of the Nasdaq Stock Exchange and a respected market maker and investment manager, worked with a handful of his employees and associates to swindle some 4,800 clients. According to federal investigators, the scheme may have begun as early as the 1970s but no later than the 1980s. When investors wanted more of their money than Madoff had on hand and Madoff’s sons learned in 2008 the truth behind the business, the scheme collapsed.

In 2009 Madoff pleaded guilty to 11 federal felonies. He had to forfeit more than $17 billion of his own money and was sentenced to 150 years in prison. On April 14, 2021, at the age of 82 he died at the Federal Medical Center in Butner, N.C.

Years before the scam imploded suspicions hung like a cloud over Madoff’s investment performance. In 2001 Barron’s published an article on the improbability of Madoff’s returns. From 1998 to 2008 forensic accountant Harry Markopolos documented extensive evidence that Madoff’s reported gains were impossible. He complained to the Securities and Exchange Commission, which launched an inconclusive investigation.

How to Spot a Ponzi Scheme

One of the biggest red flags in the investment world is the promise of guaranteed, colossal return on your money. But there are other red flags that can help you spot a Ponzi scheme. If you can’t get good information about the underlying investments and what’s generating the profits, that’s a red flag. If the investment manager discourages you from taking your profits out and pushes you to reinvest, that can be a red flag, too.

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Bottom Line

Despite numerous tragic examples of the damage caused by Ponzi schemes – Bernie Madoff being Exhibit A – retail investors still sometimes fall for such scams. The tie that binds these all together is their too-good-to-be-true promises of returns. Investing is indeed a way to build wealth, but it’s not financial alchemy, some sort of guaranteed way to fantastic gains in one’s net worth.

Tips on Investing

Consider working with a financial advisor to make sure your hard-earned money is being legitimately invested. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with several in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
Since investing in non-U.S. securities can be more complicated than investing on a U.S. exchange, it’s important to keep close tabs on how much of your portfolio goes into such investments. A free, easy-to-use asset allocation calculator can be immensely helpful in keeping your investments balanced.
If you’re just investing with an online brokerage, in mutual funds, ETFs or index funds, you don’t need to worry too much about falling prey to a Ponzi scheme. Still, it’s a good idea to know the warning signs so you don’t lose money to scammers who may try to entice you into a Ponzi scheme.