Over the last few years, the name “Bernie Madoff” and the term “Ponzi Scheme” have been used almost interchangeably.
Obviously we all know that this man was a crook and that he committed a very serious act of fraud by stealing millions of dollars from trusted investors.
But have you ever stopped to ask yourself just what one is or what a Ponzi Scheme example would even look like?
Don’t be embarrassed if you don’t know exactly what one is. When Madoff was arrested and his wife was told about his crime, she replied “What’s a Ponzi Scheme”?
As students of investing and diligent savers for retirement, it is very important that we protect our financial well-being by staying away from scrupulous investment opportunities After all, as the old saying goes:
“If an investment sounds too good to be true, it’s probably isn’t real”
Greed is a very powerful motivator, and crooks know this. When you save up a sizable chuck of money for retirement, there will be people that will try to cheat you out of it by promising you unrealistic returns.
The best thing you can do for yourself is learn how to recognize these types of scams and avoid a Ponzi Scheme right from the beginning.
Why Is It Called a Ponzi Scheme?
The term “Ponzi Scheme” is named after the con-artist Charles Ponzi. In the 1920’s, Ponzi defrauded investors using the price differences on international reply coupons (IRC’s).
The purpose of the IRC was to allow someone in one country to send it to a correspondent in another country, who could use it to pay the postage of a reply. The price of an IRC was at the cost of postage in the country of purchase, but could be exchanged for stamps to cover the cost of postage in the country where redeemed. If these two values were different, there was a potential profit.
Unfortunately, what Ponzi didn’t realize was that this system only worked as long as new investors kept coming. As the scheme continued, he started using money from new investors to pay back the old ones and get rich himself. As you can guess, this turned into a vicious cycle with no where to go but failure. Eventually the system became completely unstable and his investors lost everything.
To demonstrate exactly how that works, we’ll go through a Ponzi Scheme example that would be more along the lines of a more modern day Bernie Madoff crime.
A Ponzi Scheme Example – Step by Step:
So to summarize the history lesson above:
- A Ponzi Scheme is a fraudulent investment crime where the new money in is used to pay off the former investors.
- The investment returns and portfolio values reported to the stakeholders are basically fake and only sustained with the new incoming money.
- Eventually, as more of the former investors begin to request their money, the bubble pops and crime is exposed.
The easiest way to explain this scenario is to show you with an illustrated example. Let’s start with two groups of people:
1) The “Suckers” who are investors that will be robbed of their money.
2) The “Ponzi-Fund” which will steal the money from the Suckers.
For simplicity, this example will ignore how much money is stole by the con-artist, investment losses due to poor choices or crime-ridden investments, and tax fraud.
Cycle 1 – The Beginning:
The Ponzi Scheme begins with the con-artist convincing Sucker 1 to invest in his fund. In return for his investment, the con-artist promises a whopping (fake) 30% return! Naturally, this sounds incredible to Sucker 1 and he agrees to invest.
Cycle 2 – One Year Later:
After some time, Sucker 1 receives a statement with the 30% return and he has $2.6M!! Awesome! But what is really in the Ponzi-Fund? Probably not anywhere close to that.
For each year of the Ponzi-Fund, we’ll use the historical 10% average return (since this is what financial experts believe you can never beat over any great length of time anyways!).
Also after the first year, Sucker 2 hears about these great returns and wants in. Now the Ponzi con-artist is now promising a (fake) 40% return! Sucker 2 joins in with $1M.
Accounting for the new money and theoretical returns, as you can see by the red arrow, the two amounts are not in balance.
Cycle 3 – Trouble Builds:
After this is where the trouble begins! Sucker 1 decides to cash out with $3.64M. Oh, no! This nearly drains the entire Ponzi-Fund. The Ponzi con-artist recruits two more Suckers, 3 and 4, and again promises a (fake) 50% return. Suckers 3 and 4 contribute a total of $1M. Even with this new influx of cash, the true value of the Ponzi fund is now not nearly enough to cover all the assets.
Cycle 4 – The Bubble Bursts!
Finally, the gig is up! Sucker 2 decides to cash out but is only able to receive less than half of his statement value. Why? Because the fund is now completely exhausted! What about the rest of Sucker 2’s money? What about Sucker 3 and 4’s money? Gone! Unfortunately, it went to money Heaven
Now take this simple Ponzi Scheme example and compound it by hundreds or even thousands of investors! Also remember that the con-artist was also probably working with millions of dollars!
Not only was the crook likely stealing money for himself (he is a criminal after-all), there is also the possibility that he was investing very poorly and losing money at a very fast rate. All around, this would be a horrible way to lose your life savings.
Who Was Bernie Madoff?
In March 2009, Bernard Lawrence “Bernie” Madoff pleaded guilty to 11 federal felonies relating to using his business to create a massive Ponzi scheme. He was a Wall Street investor and the founder of the firm Bernard L. Madoff Investment Securities LLC.
Sometime between the 1970’s and 1990’s, he began to report illegitimate returns to his investors while diverting some of the money to himself and others. The amount missing from client accounts was reported at $65 billion; however, the actual losses were estimated to be approximately $18 billion.
For these crimes, he was sentenced to the maximum punishment allowed: 150 years in prison.
Readers – What do you know about Ponzi schemes? Have you or anyone you know ever been the victim of one?
Image Credit: Flickr
Love the article. I went to a Ponzi scheme event (you know the type, “buy your products to sell to others and expand your network of sellers underneath you” crap) and printed out little cards stating it was a Ponzi scheme, giving the BBB contact info. I don’t know why I felt the need to attend the event simply to subvert it. It was a sickening parade of desperate “business” people. Be careful out there.
That is kind of awesome that you did that! Way to stand up to it. I wish more people would try to divert these kind of crimes.
Matt Becker says
Great illustration. There was actually a story on the Marketplace Money podcast just this week from a guy who had been the victim of a ponzi scheme run by a friend of 30+ years. Just goes to show you that we’re all vulnerable.
That’s really too bad because its true. I’m sure a lot of people thought that Bernie Madoff was the real thing, and look at how that turned out. I hate to say it, but it kind of just fuels the fire for motivating you to manage your own money.
[email protected] says
Ah, Ponzi schemes. Great illustration and I hope that helps some people avoid them in the future.
My Financial Independence Journey says
That was a great article and the illustrations really helped explain the mechanics of a Ponzi scheme.
Thanks! I’m not sure I really understood them myself until I made the illustration. Once you start playing the numbers, you can see how easy and quick it is for things to completely fall apart.
John S @ Frugal Rules says
Great explanation MMD! I feel for the people who were taken advantage of by Madoff because many of them just lost everything. That said, this is just another example of why it’s so important to know what you’re doing when it comes to finances and not give everyone complete control over them.
Amen to that. No one watches out for your money the way you do. We could all do ourselves a favor and pay a little more attention to what’s going on.
Brick By Brick Investing | Marvin says
This is definitely a much needed post I believe Ponzi scheme gets thrown around all too often. I am not an Amway affiliate but have a couple friends who are. While it’s personally not for me they get slammed with Ponzi scheme allegations all the time but the truth is its a legitimate business. As I said before I think the business model is horrible but it is far from a ponzi scheme.
Amway got in trouble for being more of a pyramid scheme. Pyramid schemes are similar, but there are some distinct differences – mainly the fact that you have to buy the product you’re selling and sell it for more. What’s funny though (and to your point) is that that simple definition also explains how most supply chains work. Its all in how many re-sales there are and how credible the main product is.
KC @ genxfinance says
It’s easier to understand with the illustration. Will share this so that other can be made aware and avoid situations like this. It’s scary to think you’ll lose your hard-earned money because of these scams.
Thanks for offering to share it, KC. It is scary, but people will do anything to get you to part with your fortune.
[email protected] says
Didn’t know it originated with IRCs. Great trivia and analogy!
That’s something you can impress your friends with!
Shannon @ The Heavy Purse says
Great explanation and illustration, MMD. I’m a financial advisor and when the news came out about Bernie Madoff, I felt sick to my stomach that he would tarnish a profession that I love with his greed and lies. I couldn’t believe he was able to get by with it for so long. Gosh, I’d love an investment that could give me a 50% return too and sadly there are enough people who will believes those lies in the hopes of a major payday. So unfortunate and why we have to help educate people, so they can make informed decisions.
Thanks Shannon. What surprised me was just how many people and how much he was able to steal. He wasn’t a small time crook. He stole from very wealthy and higher class people. It just goes to show you that when something is too good to be true, it probably is.
Cat Alford (@BudgetBlonde) says
I laughed out loud at “money heaven” Probably money hell though. Thanks for explaining this – definitely helps me understand it a lot better!
Glad to make you laugh! Yes – money hell is more like it.
Shawn James @ PipsToday says
That was such an interesting piece of informative. I heard the term earlier but truly speaking I was unaware, what it exactly meant. I felt like I am reading a story. I have been into such scheme, but luckily I was able to get back as much as I invested. Unfortunately people who joined under me underwent loss. It was like a networking scam.
You’re welcome Shawn. And sorry to hear you were almost a victim of a scam. A lot of people think that an 8% return on stocks is laughable. But whenever someone promises you a return that is above the market average, you have to be VERY thorough to make sure it is not something shady where you are going to lose all your money. I always advocate to stick to what works and don’t get too greedy!
Do you remember what Rick Perry said during the primaries few years back? He considers Social Security as a Ponzi scheme. Think about it.
Initially, there were more workers for each SS recipient. Now, there are more recipients for each worker. The system is destined to fail at some point in the future.
Amazingly, no one wants to confront that reality now, and probably ever.
Shiplan, did you secretly read my post I have scheduled for next Wednesday? That exact topic is coming up shortly. You read my mind …
[email protected] says
I have to agree with Shilpan. When I was reading this it sounded exactly like social security and when it’s my turn, I bet all my contributions might be in money heaven! There was actually a minister from my hometown who ran a Ponzi scheme on some of his congregation members. Of course they trusted him, and he wiped out several people’s life savings and ended up in the pen. You are certainly right if it sounds too good to be true, it usually is.
If that’s how you feel, then you should stop back for my follow-up post next Wednesday. It’s about that very topic.
That’s terrible that a minister would do that. We all have a responsibility to do good, but a ministers has an extra incentive to be. His boss is God! 🙂
JC @ Passive-Income-Pursuit says
Unfortunately I have to agree about SS being in the ranks of the Ponzi scheme. The illustrations were great and really helped to explain the process. Now I can go start my own Ponzi scheme. 😉
I can’t remember if it was an article or a documentary about Madoff but it was pretty interesting. The idea was that he wasn’t doing it for the money or the power, rather pride was the main motivator. He had some great results in the beginning but as more and more money came pouring into him he succumbed to the pressure to succeed and then cheated all of those clients. The sad thing is how many people that were victims and were also pretty close to the Madoff circle.
Oh no, I hope I haven’t inspired you to start your own Ponzi Scheme process! 🙂
Isn’t that amazing that something like pride or ego (or greed) was the over-riding factor? Rather than just admit failure or even scale down when he had losses, Madoff had to keep the illusion going. The lengths some people will go to.