What is a Ponzi Scheme and How to Avoid One

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Have you ever been approached by people who can offer you investment products that promise steady yet sky-high returns? If you have, then you’ll likely have come across a Ponzi scheme.

A Ponzi scheme, perhaps colloquially known as a “Get Rich Quick Scheme”, is a fraudulent investment operation. It is named after Charles Ponzi, who used the technique to con his investors in the 1920’s.

A typical Ponzi scheme lures investors in with the promise of extremely high and clockwork-like returns.. But what goes on behind the scenes is the con-man paying-off earlier investors with money coming in from new investors.

There is no real profit being generated in a Ponzi scheme’s ‘investment’ or ‘business’ operations; there is only a transfer of wealth from new to old investors.

Understanding how a Ponzi scheme develops might give you clues on how to avoid one.

How It Begins

As the first few batches of investors receive their promised returns, it can give them a false sense of confidence in the scheme. They might then invest even more into the scheme, using their ‘profits’, and help spread the expansion of the con-job. As long as there are new investors coming into the operation to pay off earlier investors, a Ponzi scheme can last for quite some time..

How It Ends

A Ponzi scheme becomes unsustainable when the cash flow from new investors falls short of the amount needed to pay the “investment returns” that were promised to earlier investors. When this happens, the scheme will inevitably be exposed for what it is – a fraudulent operation – and investors would start withdrawing their “investments” en masse, exacerbating the collapse of it.

Famous Ponzi Schemes

Any type of asset classes can be used to start a Ponzi scheme. Health products, real estate, stocks and even gold, can be (and in many cases, has been) utilized as a vehicle of choice for a Ponzi scheme operator. Bernie Madoff, the now infamous hedge fund manager and former non-executive chairman of the NASDAQ stock exchange in the USA, once ran the world’s largest recorded-Ponzi scheme and is now living the rest of his life in jail.

Foolish Bottom Line

The reason why Ponzi schemes can last for years is because it is very difficult to prove that it is one if it has not collapsed. For instance, since 2012, famous hedge-fund manager Bill Ackman has accused American weight-loss products maker Herbalife (NYSE: HLF) of masquerading its Ponzi scheme as a legitimate business. However, he is yet to be proven right.

For investors, it is always better to be safe than sorry. As a rule of thumb, if an investment product sounds too good to be true, it most probably is.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.