What is a Ponzi Scheme?

by Manshu on January 7, 2009

in Articles

Charles Ponzi came to US from Italy at the turn of the 20th century and carried out one of the  biggest financial frauds of that time.

His initial scheme revolved around arbitraging international reply coupons and soon evolved into an elaborate financial fraud. More recently the term has been popularised by Bernie Madoff and his investment fraud which amounted to a massive $50 billion dollars!

What is a Ponzi Scheme?

Suppose you are a fund manager and 10 people invest 100 dollars each with you. That means your investment fund has got a 1000 dollars.

You do nothing with these 1000 dollars and at the end of the year – you declare 20% profits, and distribute 200 dollars to your investors.

Lured by your success – 10 more people invest 100 dollars each with you.  Now you have – 1000 dollars more, as well as the remaining 800 dollars.

At the end of the second year – you declare 20% profits again, and distribute 400 dollars to your shareholders.

So now you are left with just 1400 dollars (2000 – 200 – 400).

But that doesn’t matter because you have such a great record – that now twenty more people invest 100 dollars each with you – and you have 2000 new dollars.

So that means you have a total of 40 investors; who have invested 4000 dollars with you. But the money that you really have with you just amounts to 3400 dollars.

You are a total fake, but that won’t be exposed till the time you can raise more money than you have to repay. You can continue raising money because you have such a great track record.

The real problem will occur when all, or at least a majority of your investors need cash at the same time. When that happens – you will have no place to hide. Your scheme will be exposed for what it really is – a scam.

People who have run Ponzi schemes successfully for any length of time are usually very charismatic and appear trustworthy.

This characteristic attracts other people to them, and it takes a while to expose them. Unfortunately, the longer it takes to expose such fraudsters – the bigger the fund grows. The bigger the fund grows – the more pain it causes.

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