Here is how a Ponzi scheme works. The individual running the scheme promises abnormally high returns over a short period of time to the initial investors. These investors provide the start-up capital, and the schemer will do whatever he likes with that money, either invest it, spend it, or let it sit in a bank. Subsequent investors brought into the scheme will provide money, some of which will go to the initial investors in the form of “returns.” Subsequent investors directly fund the returns of the previous investors.
This is surprisingly sustainable for a long period of time, despite an increasing amount of required new investment. If investors are persuaded to reinvest their “returns,” very little money is handed to the investors.
Bernard Madoff, in the news lately, allegedly operated a Ponzi scheme like this. Despite years of warnings provided to the SEC, he wasn’t arrested until recently. Many smart investors fell for the scheme and lost millions of dollars. More than half of the $14 billion (as of November 1, 2008) managed by one investment advisory, the Fairfield Greenwich Group, was invested in Madoff’s securities, and they stand to lose the entire investment.
According to FGG, the company performs due diligence on their investments, including evaluation of portfolio, investment performance, and financial risks. That’s the first category of due diligence listed on their website. Madoff’s investments did not include details on the holdings, so that should have been a sign to look elsewhere.
FGG might not be a victim, however. The New York Times describes how Fairfield executives benefited greatly from the relationship with Madoff and were not shy about their newly found wealth.
As an individual investor, the chances of getting caught up in a Ponzi scheme are low, particularly if you stick with well-known mutual funds, stocks, and bonds. If you are interested in private investment opportunities, know exactly what you are buying before you hand over any money.