What Is a Ponzi Scheme?

Also called pyramid schemes, Ponzi schemes get their name from Charles Ponzi who, in the 1920s, convinced thousands of people in Boston to buy into a fraudulent postage stamp speculation scheme. At the height of his success, he had made $15 million. Eventually, however, authorities prosecuted and convicted him, and he spent the better part of a decade in prison.

Upon his release, the U.S. government deported Ponzi to his native Italy. He died virtually penniless in Brazil after working for an Italian airline that ran supplies to the fascist government during World War II.

People who buy into Ponzi schemes typically fare just as badly. They become convinced to buy into the scheme because of promises of large returns. However, most people do not even get back their principle. The only ones who stand to potentially profit are those running the scheme. Even then, the success may be short-lived when authorities eventually catch up with them.

How it works

A Ponzi scheme is a type of white-collar crime in which someone offers to invest others’ principle on their behalf, promising to pay back the dividends. More and more investors get lured into the scheme, and the person running it uses newcomers’ principle to pay back what he or she owes to the initial investors.

Eventually, however, there are not enough new investors to pay off the old ones, and the scheme fails.

What the schemes have in common

Consumers may recognize a Ponzi scheme by the secretive or complex nature of the investment strategies used. Even the explanations given may not make much sense. Regardless of the overall condition of the market, returns may be very consistent. Conversely, consumers may have difficulty receiving payments, and attempts to cash out may provoke promises of even higher returns on investment.

People running Ponzi schemes often tout little to no risk involved. This is not consistent with the nature of the market, where the possibility of higher returns inevitably involves more risk.