Is Your Special Investment a Ponzi Scheme?

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Publish date December 22, 2008 Views: 547 Comments: 5

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.

Article comments

Anonymous says:

Ponzi schemes seems not much different than the “Golden Pyramid” marketing of many “get rich quick” scams. Including the ones that attempt to employ you in order to rake off your profits. The likes of Amway and A.L. Williams on a lower scale. Although they, unlike the fund scams, actually produce a product.

Anonymous says:

I have several friends who got involved in one of these but it’s an “overseas investment” so there is little chance of recourse or arrests when it catches up with them. I’ve warned against them but they think they are going to “get rich quick.” Unfortunately this means they are really going to get poor quick.

Anonymous says:

Not me, I do only Index Based Funds.

But this just opened the door from a lot of lawsuits, just figure, I would an Entire City put all their eggs in one basket? Even if there is no SEC, the money managers are getting paid to check, investigate, check again, research, ask questions. Not say: Here is $1 Billion Dollars, do whatever you want.

I think this is a Big Blow to people that have a lot of money in Hedge Funds, those are the ones that are going to take the biggest hit.

Anonymous says:

Nice article.

It’s great that people who are scamming other people’s money are caught so it wouldn’t affect me or you.

Luke Landes says:

Hi, Trevor. Thanks for your comment.

The SEC was warned about Madoff many years ago. It makes you wonder how many scammers are not getting caught. Also, I would argue that it does affect those of us who are involved in normal, public investments like stocks and mutual funds. First, if you’re one of the people who work for the city of Fairfield, and your pension was invested by the state in Madoff’s company, you might lose your pension. Second, huge losses when perpetuated in the media might result in a drop in confidence in the stock market, keeping prices down as people sell or choose not to buy stocks.