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Ponzi Scheme Explained And The Story Of Bernie Madoff

Origins of the Ponzi Scheme A Ponzi scheme is a fraudulent investing scam in which investors are promised a high rate of return for a short-term investment. The term "Ponzi Scheme" is named after Charles Ponzi, who promised investors an amazing 50% return within a few months. He claimed that the money will be invested in international mail coupons. However, Ponzi used the money from new investors to pay returns to earlier investors. Actually, this scamming scheme can be traced back to the mid-to-late 1800s, which indicates that Ponzi is not the first person to use it although it is named after him. How Ponzi Scheme Operates? The Ponzi Scheme will not use the money from the investors to do some investment to get profits. Instead, the money from later investors are used to pay the early investors as the return. So, to ensure that a Ponzi scheme can continue working, the person who runs the scheme must do two things. One thing is to find new investors to keep the game running and maintain a steady cash flow. Another thing is try his best to prevent investors from withdrawing their funds which may cause the scheme to fall apart. To do this, they will try their best to persuade investors to reinvest their return instead of withdrawing them. For example, suppose one day your friend Bob says that you can get an annual return of 30% from an investment, and you invest $100. After a year, you get your first return of $30. So, you tell 5 friends about this great opportunity and they each invest $100 to the scheme as well. At the same time, Bob tries his best to persuade you to reinvest the return of $30 back to the scheme. So, Bob gets $500 dollars for your friends. Since you do not withdraw your $30 return, he doesn't need to pay it to you right away. In the following year, you and your friends each receive a statement saying that your investment is worth 30% more. At the same time, your friends may tell this investment to their friends and the same story will continue. If you or some friends would like to withdraw some of your investment, Bob is still able to manage it because more investors are attracted to the scheme and he has adequate cash flow to handle the small amount of withdrawal. It looks like the investment is paying out as it should and no flags are raised. If some big investors are planning to withdraw a large amount of money which may deplete the money pool, Bob will offer them an even better return if they can change their mind and keep their investment "frozen" for a longer period of time, say, 40% a year if they can freeze their investment for 5 years. When Bob manages to attract more and more investors to this game, he can still pay out some early investors who want to cash out. So, early investors usually are able to get out of the Ponzi schemes. It's the later investors who will lose their money and investments. Famous Example Due to the fact that Ponzi schemes rely on a constant cash flow from the new investments to continue to pay returns to early investors, this kind of practice is considered as illegal in most countries. A recent famous example is the story of Bernie Madoff, an American financier who executed the largest Ponzi scheme in history. He attracted thousands of investors to invest billions of dollars in his fake investment projects for more than 17 years. The reasons that his investments are trusted by investors include the following. He used to be the chair of the Nasdaq in the early 1990s, and his reputation makes lots of investors believe his story. His investments have a high return which is in the range of 10% to 20%, which is a good and consistent return but not crazy. Also, all his public portfolio appeared to stick in some blue-chip stocks which are considered as safe investments. He also showed investors that he was using a collar strategy to minimize risks, which made investors believe he was trying his best to lower the risks for his investments. When his Ponzi scheme fell apart in 2008, Bernie Madoff was sentenced to 150 years in prison and forced to forfeit $170 billion in 2009, which is the largest amount in history.