How we change what others think, feel, believe and do

Ponzi Scheme

Techniques > Confidence tricks > Ponzi Scheme

Description | Discussion | See also

Description

First invent a plausible way of making a lot of money, preferably over the shorter term. This should be easy to describe, although it must also be based on some knowledge or connection you have that is not accessible to others. It should also appear to be foolproof.

Then get people to invest. This may be a relatively small amount at first, but for higher returns will soon become a large amount.

Pay earlier investors with the money received from subsequent investors, so it appears as if the scheme is working. Encourage successful investors to re-invest their earnings and to invest more money in the scheme.

Keep a proportion of the money yourself.

If the scheme works, it will grow rapidly. Details may be spread through promotion and word of mouth from paid-off investors. It helps a lot if you can get high-credibility investors to publicly support the scheme.

When you run out of investors, declare bankruptcy and otherwise avoid your many creditors.

Discussion

The Ponzi scheme is named after Charles Ponzi, an Italian immigrant to Boston, who in 1920 offered a chance of easy money with a growth of 50% in 45 days. The idea was that of 'arbitrage', where converting dollars to other currencies and back again, minor differences in exchange rates meant that you could end up with more money than you started with. Ponzi was likely inspired by a former bank employer who funded high savings rates from investments, and William F. Miller, a Brooklyn bookkeeper who ran a similar arbitrage scam in 1899.

As with other confidence tricks, the basic lever is greed. Many people will fall for the idea of a guaranteed get-rich-quick promise. More recently, Bernard Madoff admitted in 2008 to defrauding $50 billion via his much-vaunted hedge fund.

There is also a feedback spiral, where early returns are used to confirm the validity and reliability of the scheme, so attracting greater and greater attention and investment. This leads to what has been called 'bubble'. Even legitimate growth has its limits, but Ponzi schemes promise endless growth at incredible rates. And in blind greed, investors believe the promise. There is also a significant social pressure in the way that people see acquaintances and others getting rich and who encourage them to join in.

As any scheme has time limits, its success depends on the speed and intensity of growth and 'spreading the word' is critical. Ponzi paid agents generous commissions on the investments they brought in. Within six months, Ponzi (in 1920) had brought in millions of dollars.

There are assorted variants on the Ponzi scheme. Madoff actually did run a hedge fund, but he inflated its apparent returns by paying investors with the money from other investors. 

See also

Lemons Market