With Bernie Madoff pleading guilty to 11 criminal counts yesterday and going straight to jail, without passing go, and stealing millions of dollars a lot of people are wondering exactly what a Ponzi scheme is. So was I, and I have scoured the interwebs and based on what I have learned here are the three key points you really need to know:
- It is called a Ponzi scheme because of the great Charles Ponzi who in the early to mid 1900’s was doing exactly what Madoff was doing today. He amassed the equivalent of a fortune in today’s dollars by promising huge returns and getting large numbers of investors to continue to buy in. His company was operating at a loss but continuing to pay investors with the new money being brought in by new investors.
- A Ponzi scheme is just a glorified pyramid scheme where investors are promised unrealistic returns. The first set of investors buys in, when more investors are picked up the first investors are paid out of the new investors contributions and so on and so forth.This can continue to work as long as the schemer continues to get new investors and old investors continue to reinvest. When multiple investors try to pull out at once the scheme falls apart because there was no where near enough money to pay everyone earnings and the balance of their investment
- Ponzi schemes promise you returns that seem unbelievable, and in many case they will even show you those unbelievable returns. The key here being that the returns are too good to be true because they are fake. As Dave Ramsey would say it is just like Grandma taught you, if it seems to good to be true it probably is.
Madoff claims he never promised anyone great returns but felt he had to deliver. I don’t buy it and I highly doubt anyone else will either. Until people, the government included, start to accept failure we are going to continue to live in uncertainty. Madoff’s investors trusted him to make their investments without understanding exactly what was going on. They were getting “returns” on investments that were unnatural and they didn’t question it because they were making money. The lesson here is that you need to make sure you understand all of your investments, whether you made them or they were made for you.