Bernie Madoff’s guilty plea today makes him the latest confirmed proprietor of a ponzi scheme, adding him to the long list dating back to the original namesake Charles Ponzi.  Charles himself wasn’t the first to use the technique, but his was the first large scale use in the US and so his name is infamously linked to the scheme.  So what exactly is a ponzi scheme and how do they work?

A ponzi scheme pays returns to investors either from their own money or the money of other investors rather than from profitable investments.  High returns in the scheme typically make early investors more likely to reinvest their returns and also attracts new investors.  As the scheme grows it becomes more and more difficult to maintain, since an increasing number of new investments or reinvestments are required to keep it afloat.  This is similar to a pyramid scheme except that ponzi schemes tend to have a flat hierarchy where the fraudster deals directly with victims and is the only one to profit.

Most ponzi schemes have at their core a seemingly plausible business or investment idea.  Investors are sold on this idea and believe that this is how their money will be invested.  When profits and supporting documentation start rolling in the credibility of the business idea is further enhanced, which probably inspires them to reinvest their returns or invest even more.

Suppose  a schemer promised 10 people a return of 25% on their $1000 investment within 30 days.  After the 30 days they could tell each of those people that their return had been achieved.  Given the option of having their money (with profit) returned, or reinvested most would probably choose the reinvestment option.  Some might even want to invest more or bring in friends to get in on such a good deal.  Even if half want to get out, the schemer could easily pay them $1,250 each ($6,250 total) from the $10,000 they had originally received.  Since the claimed returns are so great and investors are shown the appearance of success, payouts would likely remain very low.  As long as payouts remain lower than the money taken in, the scheme is able to continue.

By committing this illegal and fraudulent practice, those who run ponzi schemes are capable of making very large sums of money.  As in the Bernard Madoff case, they are likely to go to extraordinary lengths to make the operation seem legitimate.  Until the scheme comes crashing down, any money not used for payouts can be used to generate the appearance and success of legitimacy.  Often, the majority of the money is simply used by the perpetrator of the scheme for personal benefit.

The bottom line is that any investment that seems too good to be true is probably worth avoiding.  Even if you start small and see the promised returns materialize, you should still be cautious.  Few investment rules are as enduring as “higher returns are only paid for higher risk.”  High return, low risk investments are extremely rare and in many cases only sustainable by fraudulent practices like ponzi schemes.