These days, the term Ponzi scheme is practically synonymous with Bernie Madoff, the crooked investment manager convicted of stealing billions of dollars from his victims through fraud. The case was so prevalent in the media that there are few people who aren’t at least familiar with Madoff. However, many still do not understand how he managed to scam so many out of their hard-earned money. Let’s take a look at how such a scheme works.

Summary

The scheme is a type of investment fraud in which levels of investors are needed in order to continually generate funds that make everyone involved believe they are taking part in a legitimate opportunity with potential for financial gain. The first level of investors are paid through contributions from new investors who are convinced to take part in a promising, low-risk opportunity. However, no such opportunity exists. If the schemer can continue to recruit new levels of investors, the hoax can continue for quite a while. Problems arise when the flow of new investors dries up or when a large number of folks want to withdraw their funds.

Origin of the Name

The name of this particular type of fraud comes from Charles Ponzi. In the 1920s, Ponzi convinced thousands of people from New England to invest in a scheme based on postage stamp speculation. At the time, interest was around five percent on bank accounts. Ponzi convinced his investors that in only three months he could get them a 50 percent return. He used some of his own money to get the ball rolling, then relied on money from new levels of investment to keep everyone in the dark.

Warning Signs

There are some warning signs to watch for if you think you may be the target of a Ponzi scheme. Legitimate investments come with built-in risk. The rule is that higher returns involve higher risk. So be wary if you’re promised a no-risk, high return opportunity. If you do invest, you should expect to receive varying return amounts. Receiving consistent returns is a red flag because the market doesn’t usually maintain such consistency. Check for licenses and registration on your seller and investments. If your contact person or his firm cannot produce a license, you could be in trouble. Likewise, investments are required to be registered with regulatory bodies such as the U.S. Securities and Exchange Commission.

If you seem to be unable to get a straight answer to your questions from your investment representative, be concerned. He should be able to explain to you every detail of your investment with straight forward terms that are easy to understand. He’s likely hiding something if he talks in circles or refuses to answer direct questions. Also, you should be able to see details in writing. Finally, be very suspicious if you have trouble cashing out, receiving your payments on time or are pressured to roll over your investments on the promise of even higher returns.

Always ask for references and for thorough explanation of terms when getting involved with a financial representative who seems to be promising the world, even if this person is a friend of yours. Follow the advice offered here to avoid being the victim of a Ponzi scheme.

Related Resource: Forensic Accounting