What the heck is a Ponzi?

Ever since news broke of Bernie Madoff bilking investors out of fifty billion dollars, I’ve been trying to figure out what the heck a “Ponzi scheme” is. (Apparently, I lack the requisite historical background on Charles Ponzi.) This morning, however, I finally found a clear explanation of how it works on The Simple Dollar:

Let’s say I wanted to start a Ponzi scheme to get rich really quickly. I’d put an advertisement out there saying that I had an investment opportunity that would return, say, 25% of your investment each year, guaranteed. Obviously, that’s a claim that I’m not going to be able to back up with any real investment, but it’s a strong enough claim that I’m likely to get a few people who want to invest.

Ten people invest in my scheme the first year at $10,000 each, giving me $100,000 to work with. At the end of the year, I actually pay out that 25% to each investor, sending them checks for $2,500 each, leaving me with $75,000. These ten people are amazed by the success, so they each tell five friends about the scheme, plus my original ad draws in ten more people.

So, at the start of year two, I have fifty referred people into my scheme and ten more from my ad. They send me $10,000 each, giving me $600,000 to add to my account, leaving me with a total of $675,000. I keep promoting, and at the end of the year, I write seventy checks for $2,500 (that 25% return to each investor), totaling $175,000. That leaves me with $500,000.

Now, during that year, I’ve managed to attract 100 more customers, who send me $10,000 each at the start of year three. I now have $1.5 million sitting there, but at the end of the year, I need to pay out $2,500 to 170 customers.

I don’t want to do that, so I take that $1.5 million and vanish to South America. Of the investors, the original ten got 50% of their money back, then the next sixty got 25% of their money back. Everyone else got nothing.

So what is a Ponzi scheme? It’s one where you promise rich returns in order to get a lot of investors into your scheme, then you pay “returns” to the early investors out of the initial investments of later investors, until it looks like you’re going to be paying out more than you’re bringing in, at which point you close up shop and disappear with the loot.

Madoff’s foolery won’t directly affect me or you (unless you were invested in his fund), but it is a stark reminder of the danger of greed. 

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