Updated July 17, 2023
Definition of Ponzi Scheme
A Ponzi scheme is a swindling investment scheme to attract new investors by promising them a high rate of return and low or zero risks. The money infused by these new investors is not further invested but used to pay off profit to the earlier investors.
This scheme is highly dependent on new investors, and whenever there is a delay in finding new investors, this scheme breaks down.
Explanation
The term ‘Ponzi Scheme’ is derived from the swindler named Charles Ponzi in 1919. It is a fraudulent investment scheme. The main work of the people managing such schemes is to attract more and more new investors by providing a large amount of interest on investment with low and no risk. The new investors find this a promising scheme and invest their money in it. The invested money is used to pay back profit to the previous investors, and the managers of Ponzi schemes keep the remaining money.
Characteristics of a Ponzi Scheme
The Ponzi scheme entails the following characteristics:
- The Ponzi scheme is a fraudulent investment scheme as it uses the investments of new investors to repay the profits to the earlier investors.
- It guarantees regular returns, irrespective of the conditions prevailing in the economy.
- It attracts new investors by promising to reward them with a high rate of return, usually higher than the market return value.
- The Ponzi schemes are illegitimate and unregistered investment schemes.
- The Ponzi scheme works only because of the investor’s greed to earn more and more profit from their investment.
- It depends on the continuing flow of new investors’ investments; whenever there is any delay or time gap in finding new investors, this scheme crumbles.
Examples of Ponzi Scheme
The first-ever scam like the Ponzi scheme was noticed in the 1800’s century. Even after that, many Ponzi schemes came to notice. Some such examples are discussed below:
- Financial Advisory Consultant: In 2006, James Paul Lewis, Jr was operating as a consultant under the name Financial Advisory Consultant in California. He was later found to be running a $311 million Ponzi scheme for the past 20 years. He was sentenced to live 30 years in prison when he was found guilty.
- Swiss Mutual Fund: On October 2006, In Malaysia, a mutual fund was run by two members and their several associates, offering a return of up to 300% within 15 months of the investment period. This scam of the 21st century is currently offered to citizens of Malaysia, Singapore, and Indonesia.
- The Kirtland Safety Society (1830’s): This society was established by Joseph Smith in the year 1837 in Kirtland, Ohio. This society was a scam and had traces like a Ponzi scheme. For this, KSS Joseph Smith and his associates were accused of 17 lawsuits.
Red Flags of the Ponzi Scheme
- High Rate of Returns with Zero Risks: Every investor knows the risk in investments. There is always a risk of loss in investment; the degree of risk depends upon the rate of return; the higher the rate of return, the more the risk in investment. So, one must suspect if someone is offering a high rate of returns with no risks.
- Stable Returns: The value of investments is not stable. So, if a company provides stable and consistent returns, one must consider it suspicious.
- Unregistered and Unlicensed: Fraudulent schemes like Ponzi schemes are usually not registered with SEC or other state regulators. Also, the people working in such firms don’t have the required license to work.
- Working Methodology: The working methodology of Ponzi schemes is usually kept secret, and they don’t provide complete information about how they give such a high rate of return.
- Delay in Payment: The investors usually experience delays in receiving payment as the payment depends on the new investors. The earlier investors also suggested reinvesting their money to get a high return rate, a Ponzi Scheme.
A Ponzi scheme can be easily identified because of the nature of the returns it offers. The following are several points that must be considered:
- Offering a higher rate of return than normal market return value.
- Offering low or no risk in investment.
- Providing a consistent return on investments.
- Secrecy and not providing complete information about how they give such a high rate of return.
- Unregistered scheme with unlicensed workers working in the firm.
- Suggesting and pressurizing to reinvest to get a high rate of return
- Always looking for new investors.
Advantages
Some of the advantages are given below:
- High rate of returns: The earlier investors get a high rate of returns with the help of Ponzi schemes. They find it more profitable as compared to investing in other schemes.
- Low or no risk: The earlier investors enjoy low or risk-free investment, which is quite impossible in other investment schemes.
- No need for huge capital: There is no need for massive capital for the Ponzi scheme, as this scheme depends on new investors’ investment.
Disadvantages
Some of the disadvantages are given below:
- Delay in payment: There was a delay in payment in the Ponzi scheme. The earlier investors don’t get their return on time and are also pressured to reinvest to earn a high rate of return.
- Loss of earlier investors: If the Ponzi scheme cannot attract new investors, it will be a loss to the earlier investors as the Ponzi scheme totally depends on new investors.
- Dependency on new investors: The Ponzi scheme depends on new investors as their investments are used to repay the earlier investors. Hence, when the Ponzi scheme cannot attract new investors, the scheme collapses.
- Difficulty in filing a complaint: Ponzi schemes are usually unregistered, and if the company runs away after fraud, it is difficult to file a complaint.
Conclusion
The Ponzi scheme, being a fraudulent investment scheme, is highly uncertain and unsecured. If an investor is ready to bear the such risk and is concerned only with the high rate of return in spite of all the disadvantages it bears, then only he or she must invest. Investors should gather proper market knowledge of Ponzi investment before investing, but if they cannot do so, they can invest in other schemes.
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