Ponzi Scheme 101

What is a Ponzi Scheme?

It is a scheme which investors are paid from money collected from new investors. This continues to work as long as there are new investors keep coming in to feed the previous batches. Ponzi schemes are honoured after Charles Ponzi, an Italian who promised investors in the US and Canada that his clients will be paid 50 per cent profit in 45 days through buying postal reply coupons in other countries and redeem at face value in US through arbitrage. Ponzi continued to pay the promised returns to his clients through collection of money from other investors. His scheme caused investors to lose $20 million in 1920.

Modus Operandi

Ponzi scheme is usually promise of exceptionally high returns to investors, often they will get to be paid in installment and first few installments will be paid but investors will not see their principal. Recently, I met someone during a networking event and he shared with me a fix two years campaign promising 15% return each year for 2 years with guarantee principal through insurance. In addition, there is a referral fee of 1-3% if you introduce an investor. In financial terms, this means there is no volatility and higher return than the S&P!

Ponzi schemes are marketed very aggressively and use a network of agents who are offered high commissions. After looking at the video below, you will be surprised of the entire Madoff chronicle and how he cheated the crowd.

The principle of volatility

The guru always says "High Risk High Return", this is linked to the theory of volatility. There are no such thing as "guarantee" high return products and your principal is protected. If an investor is risk adverse and does not want any volatility, it is as good as putting your money below the pillow. This method does not take the eroding effect of inflation into account. Investors requires a higher return value due to the risk premium in order to justify the risk taken. If you wish to be a long term investor, you need to brace yourself for events when your portfolio may drop by more than 30%.

Updates to Ponzi Schemes in Singapore (26th March 2016)

Ponzi companies guarantee the principal and return of 8.5% to 15%. Some companies highlight that the principal will be protected by insurance. The insurance may cover up to say USD 1 m and looking at the above examples, they are above 1m and when the companies fold, who do you get the coverage from? It pays if you are not the last participant and the company has fresh blood. It pays to be financially literate.