How can you protect yourself from a Ponzi scheme?

The Ponzi scheme is arguably the most famous type of investment fraud,

15:32 03 March 2016

The Ponzi scheme is arguably the most famous type of investment fraud, yet even after numerous high-profile cases it continues to claim victims every year. Having a solid understanding of the basic structure of the Ponzi scheme, and how it works, will help potential victims of any age or financial means protect themselves from its lure of quick and easy profits.

What is a Ponzi scheme?

A Ponzi scheme is an investment plan that promises the initial investors a large return of interest for the use of their money. As more investors join the scheme, their monetary investment is used to pay off the guaranteed interest for the initial investors, leaving little or no money for later investors. 

The Ponzi scheme was named after one of its proponents, Charles Ponzi. In 1920, Ponzi perpetrated an elaborate scheme involving International Reply Postal Coupons (IPRCs). Used to help facilitate international mail, IPRCs sold in a weak-currency country could be sold for a substantial profit in the United States. Ponzi had the idea to solicit funds from investors to purchases these IPRCs with the promise of a 40 per cent return on the initial investment in 90 days.

Money soon flooded into Ponzi’s office, but when the fraud was revealed a few months later, thousands of investors demanded their money back and Ponzi quickly exhausted his funds and declared bankruptcy. Not only did those at the bottom of the pyramid lose their money, but the investors who did receive payment from Ponzi had to return their money as a part of the bankruptcy settlement. 

Famous Ponzi schemes

High-profile examples of this scheme can be found throughout the years since Ponzi’s first made the news, including the infamous New Era scheme of the early 1990s, but arguably the largest involved Bernie Madoff Investment Securities. The Bernie Madoff scandal resulted in hundreds of clients losing substantial amounts of money, including Hollywood actors, real estate developers, sports legends, and even Holocaust survivor and activist Elie Wiesel, as well as numerous investment firms and feeder funds with losses estimated at more than $21 billion.

Among the victims were Madoff’s own family. Mark and Andrew Madoff, his sons, alerted the authorities about their father’s Ponzi scheme, resulting in his arrest for securities fraud. Mark committed suicide two years later. Andrew went on to start a high-end disaster management company with his fiancée Catherine Hooper. Though Madoff died from lymphoma in 2014, Ms. Hooper continues as president of Black Umbrella, which sells emergency preparedness kits and customized safety plans.

Avoiding investment fraud

The key to avoiding Ponzi schemes and the other investment frauds is to be informed and ask the right questions. When considering investment, check on the licensure of the seller first. Research the investment itself, including comparing its risk-to-reward profile and whether it is a registered investment. Finally, double-check everything against independent sources.

The Ponzi scheme will continue to be used as a means of investment fraud, but having a clear knowledge of its history and outcomes, as well as arming one’s self against the fraud, will make the possibility of falling prey to this scheme unlikely.