I wish I knew what a Ponzi scheme was, but I’m too embarrassed to ask

Probably the best-known type of financial fraud is the Ponzi scheme. Here’s how it works.

Scams come in all shapes and sizes. The financial world is, unfortunately, full of them. But probably the best-known type of financial fraud is the Ponzi scheme. Here’s how a Ponzi scheme works.

The con artist promises to deliver an attractive return to investors in his or her project. Early investors put their money in, and – lo and behold! – they get the huge returns as promised. This encourages more and more people to sign up for the scheme.

However, there is no actual investing going on. Instead the con artist is simply using the new money coming in from fresh investors to pay the so-called “investment returns” to the initial investors. The rest of the money is being creamed off to fund the con artist’s lifestyle.

Ponzi schemes are named after Charles Ponzi, who emigrated to the US from Italy in 1903. Ponzi hoped to make his fortune. Instead he ended up moving from job to job and spent some time in jail for forgery.

But in 1919, he hit upon an idea based on exploiting a loophole in the pricing of postal coupons. The opportunity was real in theory, but entirely impractical in reality. But of course, that didn’t matter to Ponzi, because he wasn’t actually investing the money at all. He told investors that he could double their money within 90 days. The scheme took off fast as word spread.

Within a year, the scheme had been exposed by The Boston Post, and it collapsed. Yet by that point, Ponzi had already taken around $20m (in 1920 dollars) from 15,000 investors. The demise of the scheme also caused the failure of six banks.

Ponzi was not the first fraudster to run this type of scam. But for a long time, he was the most infamous. That is, until the 2008 financial crisis revealed that the highly-respected investor Bernie Madoff had in fact been running a Ponzi scheme under the noses of regulators for decades.

The lesson for investors? If something looks too good to be true, it almost certainly is. To find out more about scams and how to avoid them, subscribe to MoneyWeek magazine.

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