Charles Ponzi and the Ponzi Scheme

In 1920, an immigrant named Charles Ponzi living in Boston promised investors that he could increase their money by 50% in 45 days or double it in 90 days. To the astonishment of many, he delivered on his promise. He had soon built up a considerable investment base of 40,000 people who all hoped to get rich quick. These “investors” eventually lost the equivalent of $100 million in today’s money. Ponzi’s success at ripping off so many people was so memorable that he has given his name to that type of scam, the Ponzi scheme.

The Ponzi scheme works by promising seemingly unrealistic returns on investments. Since the con artist has no real experience or a track record for performing, people are naturally hesitant to risk their money despite an assurances that they could get rich if they did. Some will invariably take the chance however, either because they are too naive to understand the risks, or because they figure that it is worth a try. When the stipulated time has passed, these “investors” are often amazed to find that the claims were absolutely true. They really did make a large premium on their initial investment. That gives them confidence in the scheme, so these investors often put more money into it with the expectation of making even more of a profit. They will often tell their friends and family about their good fortune as well, generating important word of mouth for the scheme.

Ponzi schemes work not because those who operate them are such good investors, but because they are good con artists. They are not investing anything. Instead, they are taking money from newer investors to pay the promised returns to the older investors. Nothing of value is being produced, nor is there any actual trading of securities going on. So long as the scheme continues to attract new investors, however, it can continue. Ultimately, however, the scheme falls apart when its operator skips town with as much of the “investment money” as possible, when the operator fails to recruit enough new investors to make the payments to the old ones, or when the police are alerted and put a stop to it. When the scheme comes to a sudden halt, anyone with money in the scheme stands a good chance of losing it.

Ponzi schemes can and do make money for early investors, but it is difficult to tell in the early stages who is operating a Ponzi scheme and who is just trying to simply embezzle money. Anyone who leaves their money in the scheme, however, is doomed to lose it. Within six months, Ponzi had made himself a millionaire, but his investors eventually lost two-thirds of the money they had put into the system. To avoid sharing their fate, make sure you do your homework before making any investments. Make sure your broker is a regulated professional. The most important thing to remember is that if something seems too good to be true, it probably is.