A Ponzi scheme is a fraudulent investment scheme that aims to give its investors high returns at very low risks. The scheme is fraudulent because of its impractical nature and fooling people with an attractive plan which has no solid background plan. The organizers of the Ponzi scheme attract investors by stating that they will invest the money somewhere else which will yield high returns at little or no risks.
How does a Ponzi scheme work?
Let’s say that Mr. John is a Ponzi scheme maker. He sets out to attract investors to invest in his plan. In the first year, the first set of investors gain profits, and this further increases the trust among people that John is surely a profit maker. The investors are so ecstatic that they inform their friends and relatives about how good the scheme is and how much profits they are gaining from it. This is where new clients start approaching and more money starts pooling into the scheme.
People perceive that they are earning profits but at the core, it’s the new entrants’ money that is being distributed to the existing investors. John is not making any solid investments to get profits out of it and therefore ones new entrants stop approaching the whole chain starts breaking. This is where the scheme starts getting exposed.
The main reason that the Ponzi scheme fails is, there is a huge gap between the Investors’ perceived value and the actual total value. The investors keep thinking that their money is getting invested somewhere but in reality, it is just getting distributed over time and the investor does not get the amount that is promised to him.
Even though the idea of the Ponzi scheme existed before but it was in 1920, it caught a lot of attention when Charles Ponzi’s fraud got exposed and the fraud was named as Ponzi schemes. Charles in the late 1919’s saw an opportunity in international reply coupons. Due to the high fluctuation of prices in postage prices, Ponzi thought that buying cheap international reply coupons and then exchanging them for stamps would be a good opportunity. He set out his own business and gained a good reputation among people for providing a cheap alternative to the existing practice.
It was all good until when Charles started being greedy. He established a security exchange company and invited people to invest in it by giving high hopes such as 50% returns in 45 days and 100% in 90 days. This never worked out because there was no kind of investment made by Ponzi to give the returns he had promised.
How can you safeguard yourself against Ponzi Schemes?
Every ponzi scheme has some same characteristics which can be potential red flags for investors. These include characteristics such as:
- Investments not registered under any regulatory authority such as Security exchange commission
- A promise to return high returns irrespective of the market condition
- Investments strategies that have complex structures and very less transparency to its customers
So keeping the following points in mind while investing can save an investor from potential frauds.
Fast Forward to today’s era there are still Ponzi schemes happening and people are losing their life savings on it. So, the next time if you think a scheme is too good to be true, think again, investigate properly through the past financial records of the company, and invest wisely.