Financial Quotient

What is a Ponzi scheme?

WHAT DOES IT MEAN?

Ponzi-style schemes are the sort of scams where people are enticed into investing with the promise of high returns.

But the returns are paid out of funds from new investors entering the scheme. It all goes well until the flow of new cash starts to dry up.

The name comes from convicted Italian conman Charles Ponzi.

He took US$10 million from 10,000 people in Boston in the early 1920s by guaranteeing investors 50 per cent returns on investments in postal coupons after 45 days.

Ponzi thought he could take advantage of differences between United States and foreign currencies used to buy and sell international mail coupons.

The returns he offered then were dramatically higher than the 5 per cent a year which customers received for their bank savings accounts at the time. Before long, Ponzi was deluged with funds from investors. In fact, it was reported that he once raked in US$1 million in just three hours.

Like in most such scams, the early investors of the scheme were paid off to make the scheme look legitimate. Later, an investigation found that Ponzi had purchased only about US$30 worth of the international mail coupons.

WHY IS IT IMPORTANT?

Beware, you may lose everything that you put into a Ponzi scheme. It is tempting to invest in one because of the illustrated high returns.

The website of the US Federal Bureau of Investigation explains: "A Ponzi scheme is essentially an investment fraud... Instead of investing victims' funds, the operator pays 'dividends' to initial investors using the principal amounts 'invested' by subsequent investors.

"The scheme falls apart when the operator flees with all the proceeds, or when a sufficient number of new investors can't be found to allow the continued payment of 'dividends'."

In other words, money is taken from Mr B to pay initial investor Mr A. No goods are bought and sold. Neither is the money collected invested in anything.

If you want to use the term. Just say: "This is simply too good to be true. I'd better find out if it is a Ponzi scheme before I part with my money."

A version of this article appeared in the print edition of The Sunday Times on May 07, 2017, with the headline 'What is a Ponzi scheme?'. Print Edition | Subscribe