Zina Kumok writes about financial planning for Wealthsimple. She has eight years investing experience and five years experience as a personal finance writer. Her work has been featured in Investopedia, DailyWorth, MoneyUnder30 and DollarSprout. Zina runs a personal finance blog called ConsciousCoins.com and she has been a two-time finalist for ‘Best Personal Finance Contributor’ at the Plutus Awards. She has a Bachelor's degree in Journalism from Indiana University.
A Ponzi scheme is one of the oldest and most common types of scams, but it’s still used successfully every day to lure innocent people.
What is a Ponzi Scheme?
A Ponzi scheme is when someone, either a real financial advisor, planner or investor or a fake one, promises to invest your money with a certain rate of return. Instead of putting your money in whatever investment they promised, they just take it for themselves.
When you want to withdraw, they’ll give your money back by using funds from other investors. This is like robbing Peter to pay Paul. If you’re lucky and ask for your money early enough in the process, the investor will have enough money from other victims to repay what you put in. If you’re not lucky, they may give you a small portion of what you put in, claiming that the investment failed. If you don’t find out about the scheme until it’s too late, you may not get anything back, and your money will likely be gone forever. Since many of these con artists use the Ponzi scheme to fund an extravagant lifestyle, it often doesn’t take long before the funds are gone.
The name comes from Charles Ponzi, an Italian con artist who duped investors in 1920 with a postage stamp investment that promised 50% returns. Many investors handed over their life savings. He cheated tens of thousands of people out of $15 million before he was caught.
How to Spot a Ponzi Scheme
Ponzi schemes have persisted because criminals have gotten clever about how they disguise their scam, especially in the age of social media and new forms of advertising. But there are several red flags you can watch out for.
Many Ponzi schemes will try to guarantee a certain return over a short period of time, like a 20% return in three months. These returns will usually be much higher than anything you can find in the stock market. The more ludicrous the return, the more likely it is that it’s a Ponzi scheme.
According to the Securities and Exchange Commission, someone who perpetrates a Ponzi scheme will also promise high returns without any risk. This is one of the biggest signs to watch out for because every real investment always has some risk unless it’s a savings account at a bank. If an investor is promising 15% guaranteed annual returns with no risk, it’s likely a Ponzi scheme.
They’ll also often try to show consistent returns over a long period of time. Most investments have downturns, especially if the economy is experiencing an overall downturn.
People who operate Ponzi schemes are also often unlicensed investors. They may have been real investors at some point, but have let their license lapse. Before putting your money in someone else’s hands, you should verify their licensure on your own. Don’t take their word for it. You can look up a license through your government’s organization. In the US, both state and federal governments can license investors. Always get a license number and look up the broker for yourself. Don’t rely on them to give you their information.
Ponzi schemes can last for weeks, months, or even years, depending on how many new clients join. If the Ponzi scheme has a regular influx of new investors, it can go on for a while. If new recruits dry up, then the fund will go down quickly.
How long a Ponzi scheme lasts also depends on the greed of the creator.
Ponzi Scheme Example
Bernie Madoff is the most famous example of a Ponzi scheme mastermind. His Ponzi scheme started in the 1990s and only ended when he confessed his crimes to his sons, who reported him the next day.
Madoff’s Ponzi scheme was the largest in history, with almost $65 billion in assets. It started to unravel partially because of the 2008 global financial crisis.
Madoff’s Ponzi scheme is so well-known not only because of its size, but because of who it affected. Celebrities like Steven Spielberg and Kevin Bacon and Holocaust survivor Elie Wiesel were some of the victims.
His Ponzi scheme lasted so long because Madoff seemed to be so successful and accomplished. He had been chairman of the NASDAQ after all. Many of his victims say they trusted other people who invested with Madoff so it became a self-sustaining Ponzi scheme.
In 2009, he was sentenced to 150 years in prison. The US Department of Justice reports that it has repaid $772.4 million to more than 37,000 of Madoff’s victims.
Pyramid Scheme vs. Ponzi Scheme
Pyramid schemes and Ponzi schemes often get mistaken for each other, but they are quite different.
A pyramid scheme is a scam where one person will promise you money if you recruit other people to join and give money. A pyramid only makes money when people beneath you hand over money.
If the only way you can make money is by getting other people to give away their money, then you’re involved in a pyramid scheme. Pyramid schemes are illegal in both Canada and the US so if you think you discover one, you can report it to the authorities. Participating in a pyramid scheme knowingly and recruiting others may constitute a criminal act.
How to Avoid a Ponzi Scheme
People often get caught up in Ponzi schemes because they’re promised high results that other financial planners and advisors can’t guarantee. They may also see people they respect and admire taking part in the Ponzi scheme.
The best way to avoid a Ponzi scheme is to invest your money with a company that tells you clearly where your money is going. Many people fall for Ponzi schemes because they don’t know where their money is going and they’re too intimidated to find out.
Learn about investing and understand how the stock market works. Question the friend (or friend of a friend) who tells you about a hot tip that only he or she has access to. Ask them exactly where they’re putting their money.
Ask to see regular statements, although the can be misleading, like the ones Bernie Madoff provided for his clients.
Above all, don’t be greedy. No financial planner, broker, or investor can promise huge returns with 0% risk. A reputable planner should explain how past returns never guarantee future success and how the market is completely unpredictable.
Ponzi schemes often target people who are more susceptible to scams, like the elderly. Some preliminary research suggests that old people may be specifically vulnerable to financial scams, even if they don’t have any diagnosed cognitive ailments, live on their own or are otherwise mentally sharp.
If you have a parent who lives alone or who is having cognitive issues, you should talk to them about where they’re investing. If possible, ask them to appoint you to have power of attorney and set limits on how much they can withdraw or transfer without your approval.
They may be lured in by the promise of a free meal or someone doing a presentation at their retirement community. One notable Ponzi scheme targeting seniors and their retirement funds advertised itself through the newspaper and on the radio and TV. They defrauded about 8,400 seniors out of $1.2 billion before declaring bankruptcy.
The best way to avoid a Ponzi scheme is to learn where to invest your funds and what’s realistic. For example, the S&P 500 has averaged about a 10% return over the past 90 years. The S&P 500 is the benchmark upon which other investments are most often measured, because it includes the 500 biggest companies in the US.
Investing money is like losing weight. People know that choosing an index fund, saving in it regularly, and letting it grow for decades is a stable investing approach. But this requires a dedicated long-term approach, like eating a balanced diet and working out a few times a week. And it involves fluctuations.
Investing in a Ponzi scheme is like finding a crash diet. It might work well for a few weeks, and you might shed more pounds than you ever have before. But the crash inevitably happens, and you’re back to where you were before.
There’s no secret trick to investing or picking the right stocks. For most people, buying and holding index funds is the best way to save for retirement. Yes, sometimes you can get lucky and find the next big thing, like Bitcoin, at the right time.
But that approach is what leads people to Ponzi schemes. It makes them think that there’s a smarter, faster, and better way to save and invest. This could be because they’re impatient and don’t want to wait decades to see their money grow or because they only have 10 years until retirement and need their money doubled now.
There’s no secret hidden trick to investing. If it sounds too good to be true, it probably is. And it’s likely a Ponzi scheme.