Definition
By definition, a Ponzi scheme is a fraudulent investment that involves the payment of purported returns to existing investors from funds contributed by new investors. It is an investment system where the investment profits are paid with the money from other investors, and those who experience profit believe the profits come from non-investors such as business activities, or the earnings and growth of a company.
Ponzi Scheme
A Ponzi Scheme is a scam, promising high returns on investment. This is a scheme that has been designed to swindle investors into investing their money in low–risk ventures, by promising high profits in return. In the beginning, a Ponzi Scheme might actually be able to pay investors the promised rewards for their investment. This is because, initially, the scammers might be able to make money by attracting new investors towards their deceitful scheme. However, once their con is exposed and new investors stop coming, the scheme might usually collapse on its own.
Origins
The Ponzi Scheme is named after a man called Charles Ponzi, who served as a clerk in Boston. He was the one who initiated this form of financial scam in 1918. He promised his clients a profit of fifty percent of their investment, within a small duration of 45 days, and a hundred percent profit, in 90 days.
He was able to scam his clients by claiming to earn high profits through purchasing cut-price postal reply coupons from different parts of the globe, to redeem them on face value in the U.S.
What he actually did was pay early investors using the money of those who invested later on. His fraud lasted for a while and then, suddenly collapsed, costing his investors a loss of 20 million dollars and wiping them off financially.
Ponzi’s scam became so famous that it was the first of its kind to be spread nationwide. In the following years, inspired from this scheme many financial frauds were performed, but none of them gained as much popularity as the one initiated by Charles Ponzi.
The difference between a Ponzi Scheme and a Pyramid Scheme
Ponzi Schemes and Pyramid Schemes are very similar in context. Both are used to swindle investors into investing large amount of money in hopes of great profit. Both schemes use the funds from later investments to pay back the early investors. However, there is a significant difference between the Ponzi and Pyramid schemes.
While the Ponzi scammer gathers money from new investors and distributes them evenly to all investors, the Pyramid scammer will allow each investor to benefit directly from the investment depending on the number of new investors that have been recruited in the scheme. This means that the investor who stands at the top of the investment pyramid will never have any access to all the money that has been gathered.
Further Reading
- Retracted: Financial Literacy, Ponzi and Pyramid Scheme in Indonesia – journal.unnes.ac.id [PDF]
- Financial disaster as a risk factor for posttraumatic stress disorder: Internet survey of trauma in victims of the Madoff Ponzi scheme – academic.oup.com [PDF]
- Madoff Ponzi scheme exposes the myth of the sophisticated investor – heinonline.org [PDF]
- Does issuing government debt needed as a Ponzi scheme in Islamic finance: A general equilibrium model – ideas.repec.org [PDF]
- Debt and taxes: Ponzi finance, dynamic efficiency and government solvency – papers.ssrn.com [PDF]
- The modern commercialization of science is a passel of Ponzi schemes – www.tandfonline.com [PDF]
- The Miller‐Modigliani 1961 Ponzi scheme, alias “dividend irrelevance” – www.emerald.com [PDF]
- How do investment ideas spread through social interaction? Evidence from a Ponzi scheme – onlinelibrary.wiley.com [PDF]
