Most of us have heard of Ponzi schemes but do we actually know how they work and where did they come from?
What is a Ponzi Scheme?
A Ponzi scheme is an investment opportunity that offers exceptionally high return on investment in an extraordinarily short time frame.
The promised returns in a Ponzi scheme are so high that no other form of investment can compete with what is promised.
The high return on investment takes advantage of the greed of people and their desire to get rich quickly. Who wouldn’t want to make a lot of money fast?
A typical Ponzi scheme works in a way where the investors are asked to invest a sum of which they get back a certain percentage every week. In reality however the investment gains are being paid back from the original amount invested.
Example of a Ponzi Scheme
Here is how a typical simplified Ponzi scheme could work.
The person running the Ponzi Scheme asks you to invest 1000 dollars in his investment opportunity. He promises to pay you back 200 dollars every week for the rest of the year.
You decide to give him the money. Let’s call this week 0. Here is what will happen.
- Week 0 – Invest 1000 dollars in a Ponzi Scheme
- Week 1 – Get paid your first “profit” of 200 dollars.
This 200 dollars is actually paid back to you from the 1000 dollars you “invested” in the first place. That means that after getting back your 200 dollars the person running the Ponzi scheme is left with 800 dollars that he got from you.
Here is what will happen during next weeks.
- Week 2 – Get paid your second 200 dollars. Your “account” with the scheme runner has 600 dollars left.
- Week 3 – Get paid your third 200 dollars. Your account has 400 dollars left. You start to think that this is a great way to make money.
- Week 4 – Get paid another 200 dollars. Your account in the Ponzi scheme has 200 dollars left. You decide to let your friends know about this great investment opportunity.
There are 3 ways a Ponzi scheme can go on from there.
- You get all your money back + you will start getting back the additional profit that was promised to you. If this is the case you are in luck. The people running Ponzi schemes typically pay the money back to the first people who started out with them because this makes other people confident that they will also get a huge profit.
- A lot of new people join the scheme because they saw that it works. Their money is used like shown in the example above to give them back their “profit”. Their money is also used to pay you the profit that was promised to you but what your original investment didn’t cover.
- The Ponzi scheme is halted and the conman flees with the money. If enough people have joined the con the runner of the Ponzi scheme will have a very large amount of money going through his hands every week. If the sum is large enough he simply stops paying back the money. He will walk a way with a very large amount of money!
Meet Charles Ponzi – the father of the Ponzi Scheme
The Ponzi scheme is named after a conman called Charles Ponzi who ran an extraordinary scheme in New York City in 1920.
Charles Ponzi was actually born as an Italian named Carlo Ponzi in 1882. He moved to New York in 1903 where he subsequently changed his name to Charles.
There is little known about the earlier days of Ponzi because of his habits to fabricate facts.
Charles Ponzi arrived to America with just $2.50 in his pocket. He had spent the rest of his money gambling on the ship that he took to get to the States.
After getting famous Mr Ponzi told the New York times: “I landed in this country with $2.50 in cash and $1 million in hopes, and those hopes never left me”.
In 1919 and 1920 he pulled off the greatest Ponzi Scheme that was ever seen, earning him more money than he could hope for plus a place for his name in history.
The original Ponzi Scheme
Charles Ponzi offered people to get a 50% profit in 45 days when investing their money in discounted postal reply coupons. A prospect of getting a 100% profit in just 3 months meant that there was no shortage of clients.
The way Charles Ponzi explained his business to people investing with him was that he was buying discounted postal reply coupons from other countries and then redeeming them in the US for their face value. The difference between the buying and the selling price would be where he got his profit.
Ponzi hired agents and payed them generous commissions for every client they brought in and every dollar they made.
The word spread and by February 1920 Ponzi made about 5000 dollars a day (approximately $60 000 US dollars in 2010). In March he already made $30 000 a day and by May 1920 he made over 420 000 dollars a day.
The first people that invested their money in the Ponzi scheme made 200 and 300 percent gains. Their recommendations and approving stories in newspapers made more and more people take up the offer. At the height of business over 1 million dollars was deposited to Charles Ponzi’s accounts in every 3 hours (12 million dollars every three hours in 2010 money).
As time passed the stories in the papers became more suspecting but after a financial writer who said that there was no way Ponzi could make such money was sued for 500 000 dollars – the stories seemed to calm down.
The newspapers however were only seemingly holding back. The Post hired financial analyst Clarence Barron to examine Ponzi’s scheme. Barron found that although Ponzi offered huge returns he did not invest his own money with his company. Furthermore, Barron calculated that in order to cover Ponzi’s investments there had to be at least 160 million postal reply coupons in circulation – however there were only about 27,000.
On August 11th 1920 The Post came out with a front page story of how Charles Ponzi had been involved with forgery and cons in Montreal 13 years before. This was the end of the Ponzi Scheme.
People had mortgaged their homes and invested their life savings into Ponzi’s Scheme – such was their desire to make money. Officially more than 40 000 people fell victim to the original Ponzi Scheme, unofficially this number is probably around 100 000 victims.
Did you know?
As the person behind the Ponzi Scheme Charles Ponzi was a great conman. The word conman comes from the words CONfidence MAN. A conman is someone who uses his skills to inspire confidence in himself with other people so that he can go ahead with the fraud he is planning. Charles Ponzi had tens of occurrences where his scam was almost discovered but because of his confidence he was able to persuade people and make them believe that what he was doing was legitimate.
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