How to Spot a Ponzi Scheme

Charles Ponzi

Charles Ponzi

Ponzi schemes are named after Charles Ponzi, a con man who came to the U.S. from Italy in 1903 with just $2.51 in his pocket. By 1920 Ponzi had made millions by convincing people to invest money in his company. He promised–and for over a year, delivered–50% profit in 45 days, or 100% profit in 90 days.

He claimed the profit was coming from the buying of discounted postal reply coupons, which it took a while for many to realize, didn’t make him enough money to be able to offer such returns. In reality, what he was doing was paying previous investors with the money received from new investors.

Ponzi Schemes work as long as new investors continue to join the scheme. Consider the example below, of a scheme that offers 50% returns. To simplify, we’ll assume only one person joins the scheme per day, and that each member is promised 50% profit the very next day:

Day # Members who joined Money collected for the day Balance before payouts Money paid out for previous day Ponzi ending account balance
1 1 100 100 0 100
2 1 100 200 150 50
3 1 100 150 150 0
4 1 100 100 150 -50
5 1 100 50 150 -100

The table above illustrates why ponzi schemes can never go on for very long. In this simple example, you can see that by the fourth day, there isn’t quite enough money to pay the person who joined the previous day. Not only do ponzi schemes need a steady supply of new members, but the number of new members joining has to exceed the number of members that have yet to be paid.

The most successful ponzi scheme in history is, of course, Social Securitysince the benefits received by seniors far exceed the amount they put into the system, which is why the system relies heavily on the money put in by those younger. But that is a topic for another day.

Since ponzi schemes are illegal, many schemers will try to “legitimize” their “business” by creating a very simple job for their members to do in order for them to get paid. This way, they can claim that they are merely paying people to do a job, and not just paying them for nothing, with the new money coming in.

Sadly, many of the people who “invest” in such schemes are those who don’t have a lot of money to begin with, and are convinced that they have finally found a way to make money for doing almost nothing.

It is this promise that you can make money without having to work for it, that makes ponzi schemes so easy to identify. All you have to do is ask yourself the following questions:

  1. What are they paying you for?
  2. Is the job you are doing worth what they’re paying you?
  3. Would you pay someone that much to do that job?
  4. If it doesn’t seem like the job is worth what they’re paying you, then why and how are they paying you?

TelexFREE is a great example of a scheme that is still ongoing, and which I believe will collapse soon enough. I’ve heard from members that TelexFREE promises them $100 per week per “franchise” for the simple job of posting just a few ads online, a job that clearly isn’t worth $100 per week.

Many who join ponzi schemes actually do make money, while the company is able to attract new members, but just like with Charles Ponzi’s scheme, those who do, get so excited, that they keep re-investing their profit. This continues until the whole thing collapses and all the new members, along with everyone who was foolish enough to re-invest, end up worse off than they were before, when they convinced themselves that it’s possible to create wealth without risk or effort.

UPDATE (4/14/14): The company behind the Ponzi scheme TelexFREE that I mentioned above has declared bankruptcy.

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