A Ponzi scheme is a fraudulent investment scam promising high returns with little risk to investors. Named after Charles Ponzi, who orchestrated such a scheme in the early 20th century, this type of scam lures in new investors by offering profits to earlier investors from the new recruits’ funds, rather than from profit earned by the operation of a legitimate business.

How Does a Ponzi Scheme Work?

The core of a Ponzi scheme is simple: it uses the money from new investors to pay returns to earlier investors. For example, imagine a scammer named A who promises a 10% monthly return on investment. Investor B, intrigued by this offer, gives A $1,000. A then pays B $100 the next month as “profit.” However, this $100 isn’t profit; it’s just a portion of B’s original investment being returned. The scammer uses this tactic to attract more investors, say C and D, who each invest $1,000. With $2,000 from C and D, A can now pay B another $100 and still keep $1,800 for themselves.

The scheme grows as more people get involved. Early investors often reinvest their returns, further feeding the cycle. But since there’s no actual profit being made, the scheme eventually collapses when the scammer can’t recruit enough new investors to pay returns to earlier investors. At this point, the scammer typically disappears with the remaining funds, leaving most investors with significant losses.

The Unsustainable Nature of Ponzi Schemes

No Ponzi scheme can last forever. It relies on a continuous influx of new investors, which is inherently unsustainable. When the pool of new investors dries up, or when too many investors demand their money back at once, the scheme unravels. While some early investors might see returns, the majority will end up losing their money.

Recognizing the Red Flags

Ponzi schemes often share several telltale signs:

1. Guaranteed High Returns: Legitimate investments fluctuate with the market. If someone promises consistent high returns regardless of market conditions, be wary.
2. Lack of Transparency: Scammers often avoid providing details about how the money is being invested, keeping investors in the dark.
3. Unusual Account Setup: Be cautious if you’re asked to deposit money into an account not in your name or controlled by the promoter.

Ponzi schemes continue to deceive investors, but by understanding how they operate and recognizing the warning signs, you can protect yourself from falling victim to these fraudulent scams.