In 1920 Charles Ponzi swindled investors out of millions of dollars but similar scams are still alive and well today.
Continuing our series on famous investment scams, we turn our attention to Ponzi Schemes. Named after Charles Ponzi, and recently popularised by Bernard Madoff, they rarely fail to reel in their victims.
A Ponzi scheme is quite a simple scam that attracts investors by promising unrealistically high returns. Then it just takes money in from new investors and pays it out to existing ones (and, more importantly, to the founders of the scheme). Such schemes rarely, if ever, actually do any real investing with any of the money. And even if they do, it is usually just a bit of 'window dressing' and their investment profits are pretty much negligible compared to the money they need to honour their promises.
To pay a good return, a Ponzi scheme needs to draw in more and more investors at every generation. So if a scheme promises, say, a 20% return every 3 months, in every three-month period it needs to find 2 new investors for every 10 already in the scheme in order to cover their returns.
How many?
To keep that up for, say, 10 years, adding 20% more investors every three months, how many suckers to you think a scheme would need to draw in? A couple of thousand maybe? It would actually require nearly 150,000 investors in total.
Obviously, that's not going to work for long, and most Ponzi schemes don't have a chance of lasting anything like 10 years. They are guaranteed to collapse, and the founders' plans are usually to take the money and run before that happens, and before the regulatory authorities investigate and take action.
But by clever means, a Ponzi scheme can be run for quite a long time. The tactics include persuading existing investors to keep reinvesting their returns (often using quite high pressure tactics), paying out some early punters quite large sums and then using them a publicity material, and dressing up the scheme with fancy and sophisticated-sounding investment jargon.
It's not just the ignorant
They know they'll be asked how they're making their money, so they'll call it something like "High yield hedge fund futures", because everyone has heard of hedge funds and just about nobody really knows what they are. And "high yield" sounds good. And as for "futures", well, the future is always rosy, isn't it?
You might think you wouldn't fall for such a transparent con, but, Bernard Madoff managed to swindle a large number of wealthy and supposedly sophisticated investors out of nearly $65m with his Ponzi scheme. His big mistake was not having an exit strategy -- he was too high profile to take the money and disappear, and he knew it would eventually collapse and he'd be caught. Madoff's fraud is a salutary lesson that the well-heeled can be as gullible as Albanian peasants.
So who is this Ponzi guy?
Charles Ponzi, after whom the scams are named, was an Italian immigrant who arrived in the USA in 1903. He wasn't the first author of the eponymous scheme, but his fame was assured by the size of his swindle.
What he did was he spotted an arbitrage opportunity in postal reply coupons. These were coupons that could be bought in the USA at US postage prices and sent overseas with a letter, and then used to cover the return postage for a reply. But they could also be traded for the equivalent postage stamps in destination countries, and as postage was cheaper in the USA, there was a potential profit to be made.
But honestly trading them wasn't for Charles. Instead, he used them as an excuse to launch a scam, claiming that a profit in excess of 400% could be made, and promising 100% returns within three months to people who invested money with him.
Doomed from the start
Naturally it was doomed to collapse, and when investigators probed his affairs and discovered there would need to be 160 million coupons in circulation to cover the scheme, when there were in fact only around 27,000, the game was up. But by then, millions of dollars had probably gone through Ponzi's hands -- nobody ever discovered the total amount.
Ponzi spent some time in various prisons, and ended his life in the poverty that he so richly deserved.
Would you be caught?
I'm sure we all like to think we're far too clever to fall for such a scam, but greed really can quite easily overcome educated common sense -- as P.T.Barnum famously didn't say, there really does appear to be at least one sucker born every minute.
More from Alan Oscroft:
