You may have heard the term, but what IS a Ponzi scheme?  Just about everybody has heard of pyramid selling and pyramid schemes, but few seem to have heard of Carlo Ponzi whose name is synonymous with illegal pyramid scams.

Basically it is a system whereby  investors are persuaded to sell practically worthless investments to other investors, with the promise of great riches if each investor subsequently sells the investment in turn to other groups. It began in the 1920s when Carlo Ponzi promised a 50% return on investment in international mail coupons in only 45 days.  He raked in almost ten million dollars (in 1921!), though he himself only ever purchased around $30 worth of the coupons.

As the promissory notes of the early investors matured, they were settled by the payments of new investors.  Obviously this could not continue without the bubble eventually bursting.  As more and more notes matured, there were eventually not enough new investors to repay them.

A pyramid scheme is very similar, only there is generally no product involved.  Members are basically paying for the right to recruit other members below them in the pyramid, or chain. This type of scheme is still operating to this day.  I am sure that you are acquainted with the principle of ‘chain letters’. 

The letter instructs you to send, say, $10 to the person named at the top of a list provided.  You then add your name to the bottom of the list, and remove the top name. You now have to send a copy of the letter to as many people as possible.  Eventually, your name gets to the top of the list, and since the number of participants grows at an exponential rate, you cannot fail to receive thousands, if not millions, of dollars.  Only it fails to work, unless you are one of the first few in the scheme, since simple math indicates that if you are tenth in the list,  ten billion people would have to participate before you got full benefit of the scheme when your name reached the top.

The usual outcome is that you receive nothing. This is the way that illegal pyramid schemes work.  Money paid by new investors goes to pay the earlier investors until it all collapses due to a lack of investors.  The vast majority lose all of their investment.

Since it is illegal in most countries to operate a sales scheme without a product, you will frequently find that the letter includes a short ‘report’ that your investment is being used to purchase, and that you are intended to sell to those below you in the list.  This report is frequently nothing more than instructions to others on how to operate the scheme.

Another ploy is that when you send off your ‘investment’ to the top name you are often asked to include a written statement that it is a ‘gift’ .  It is not illegal to send someone a gift.

There are several other ways that people have used to try to overcome the intrinsic illegality of these systems, but they are all based on the same concept.  They must all ultimately fail since the whole population and more would have to join before the later members receive any return on their investment.

True Ponzi schemes have a slight distinction from pyramid schemes in that real products are involved.  These could be Ponzi’s mail coupons or other investments, but it is only a minor distinction since the investment makes no income in its own right.  The only money going into such schemes are from the members, and so simple math proves that for a scheme where each member has to recruit 10 others, 90% must fail to make any money at all.  Even if the number of recruits drops to 5,  it must still have an 80% failure rate. 

There is a distinction between legal Multi Level Marketing (MLM) schemes and illegal pyramid schemes.  A legitimate scheme must have a real product of value that can be used by the buyers in its own right, rather than to sell on to others who join the scheme.  Furthermore, earnings of people involved in the scheme should not come solely from new members joining the scheme. A legitimate scheme should not require you to recruit others before you can make money.

The salient features of a Ponzi scheme are that the product is either worthless or being sold at a vastly inflated price well above its intrinsic worth, and itself earns no money for the investor, and that money is made entirely from the investments made by those joining the scheme at a later stage.  The only way not to lose your money in such a scheme is to recruit others.

The initial 10 – 20% of investors make a lot of money, and the rest lose everything.

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