How To Avoid Ponzi And Pyramid Schemes
Named from Charles A. Ponzi, who defrauded hundreds of investors in the 1920s, a Ponzi scheme pays off old investors with money coming in from new investors. 5 min read
Investors generally set two objectives in evaluating an investment:
- As high a return as possible ("yield" in the form of interest, dividends and/or long term appreciation), and
- Safety. Ponzi and pyramid schemes normally attract unsuspecting investors by the promise of an unusually high rate of return.
Experience has demonstrated, however, that as a general rule, the higher the return on an investment, the riskier it is likely to be. In other words, the higher return is usually paid to justify the higher risk. The prudent investor will compare the return promised or proposed with that generally being realized on other types of investments.
It is impossible to describe thoroughly the various forms Ponzi and pyramid schemes might take, but these operations do have certain hallmarks. You should be particularly cautious when an investment opportunity emphasizes:
- very high yield;
- quick return;
- "a once in a lifetime" opportunity; and
- the chance to "get in on the ground floor."
Ponzi Scheme
Named for Charles A. Ponzi, who defrauded hundreds of investors in the 1920s, a Ponzi scheme pays off old "investors" with money coming in from new "investors." It works this way:
Example:
- Investor A gives Promotor ("P") $1000 on P's promise to repay $1000 plus $100 "interest" in 90 days.
- During the 90 days, P makes similar promises to Investors B and C, receiving $1000 each from them.
- At the end of the first 90 day period, P may offer to pay A the $100 "interest" and to return the original $1000. More likely, he will invite A to "re-invest" the $1000 plus the $100 "interest" for a similar, or higher, return at the end of another 90 days.