Personal Finance 101: On Ponzi Schemes and Other Things

Understanding Ponzi Schemes and Making the Right Investments

personal finance 101One of the biggest financial stories of the last month or so was the revelation that Bernie Madoff, a legendary stock trader if there ever was one, had perpetrated a giant Ponzi scheme on investors, bilking them out of fifty billion dollars.

Personally, I found the story fascinating, and apparently many of you have as well, because I’ve received a ton of questions and comments about Madoff and Ponzi schemes and pyramid schemes. Here are some of my thoughts on the most common questions brought up by readers, especially in terms of understanding what happened and what impact it has on you and your future moves.

What’s a Ponzi scheme?

Most of the descriptions of Ponzi schemes that are floating around out there in articles are really confusing, so I thought I’d start off with a clear example of a Ponzi scheme.

Let’s say I wanted to start a Ponzi scheme to get rich really quickly. I’d put an advertisement out there saying that I had an investment opportunity that would return, say, 25% of your investment each year, guaranteed. Obviously, that’s a claim that I’m not going to be able to back up with any real investment, but it’s a strong enough claim that I’m likely to get a few people who want to invest.

Ten people invest in my scheme the first year at $10,000 each, giving me $100,000 to work with. At the end of the year, I actually pay out that 25% to each investor, sending them checks for $2,500 each, leaving me with $75,000. These ten people are amazed by the success, so they each tell five friends about the scheme, plus my original ad draws in ten more people.

So, at the start of year two, I have fifty referred people into my scheme and ten more from my ad. They send me $10,000 each, giving me $600,000 to add to my account, leaving me with a total of $675,000. I keep promoting, and at the end of the year, I write seventy checks for $2,500 (that 25% return to each investor), totaling $175,000. That leaves me with $500,000.

Now, during that year, I’ve managed to attract 100 more customers, who send me $10,000 each at the start of year three. I now have $1.5 million sitting there, but at the end of the year, I need to pay out $2,500 to 170 customers.

I don’t want to do that, so I take that $1.5 million and vanish to South America. Of the investors, the original ten got 50% of their money back, then the next sixty got 25% of their money back. Everyone else got nothing.

So what is a Ponzi scheme? It’s one where you promise rich returns in order to get a lot of investors into your scheme, then you pay “returns” to the early investors out of the initial investments of later investors, until it looks like you’re going to be paying out more than you’re bringing in, at which point you close up shop and disappear with the loot.

How did Madoff get away with this kind of scheme?

Madoff’s primary tool for making the scheme work was the respect from others he had built up during his long career on Wall Street. He had been the chairman of NASDAQ and was intimately involved in the organization and technology involved in setting it up. He had also been running a fund for many, many years and had discussed at length his investing strategies (which were pretty complicated).

At some point along the line, Madoff began to not see the success that he had been claiming with his investing strategy and quietly began to convert things into a Ponzi scheme. He began to focus heavily on marketing his investment fund, attracting new investors all the time, and when these people would invest, he would use that money to pay out to earlier investors who were leaving the fund. So, for example, if he were taking in new investments and could actually return 8% on them, he was claiming a 12% return and actually paying that out to investors who were leaving the fund.

It’s easier to think of this in raw numbers. Let’s say you have $100 of someone else’s money and you have that invested somewhere where you can earn 8% on it. You tell that person (and everyone else who will listen) that you can earn 12% on their money. After the first year, that initial person wants their $100 back (with that 12% return), but five more want to invest. You take the $100 they invested, plus the $8 you actually earned, plus the $500 the new investors gave you, and you pay out $112 to the original investor. Now you have five investors, but you have only $496 and it’s only earning 8%. Next year, four of those investors want out with their $112 each (total $448). You have only $535.68 on hand, but you pay out the money. You actually only have $87.68 on hand right now (earning 8%), but the lone remaining investor believes he has $112 with you (earning 12%). It won’t be good when that last investor comes to collect his money.

That’s eventually what happened to Madoff. When the stock market tanked in late 2007 and 2008, investors wanted their money out in droves and he simply ran out of money to pay the inflated returns he had been promising everyone because he wasn’t actually earning those returns.

Can any of this possibly affect me?

Madoff’s scheme won’t directly affect you unless you were invested in the scheme.

So why should we pay attention to it at all? It’s a stark reminder of the danger of greed. Madoff got greedy with his own fund and kept seeking more investors so he could keep living the high life. The investors themselves were greedy because they were trying out investments that they didn’t really understand just in the hopes of getting a big return.

What warning signs should I look for?

Here’s the big one: if someone is promising you returns that blow away what can be found easily in the S&P 500, don’t believe it. They’re selling you something fishy. Investing returns in the double digits do not grow on trees, and if they’re guaranteed, something inappropriate is likely going on. Avoid it for your own safety.

That’s not to say you can’t earn returns higher than 10-15% or so – one certainly can. But a person is not going to find that return by investing in someone else’s investment package. You’re much more likely to find it in small events in your everyday life. For example, a couple years ago, I turned a nice and quick profit reselling Nintendo Wiis when they were very hot, earning far more than a 10% annual return. However, such opportunities aren’t sold as investment packages.

Similarly, if you don’t understand how an investment works, don’t invest in it. This is an investing rule I always follow. The only stocks I purchase are very broad mutual funds that basically amount to investments in the idea of American business as a whole. Why? I understand how they work. I don’t invest in individual companies. Why? I don’t have enough information to truly understand how they work. I don’t invest in non-index mutual funds. I don’t invest in hedge funds. I don’t invest in anything I hear about from friends or acquaintances.

If I don’t know how it works, I’m trusting someone else to understand it for me – and, more importantly, I’m trusting that person to always have my best interests at heart. With people like Bernie Madoff out there, it’s not a risk anyone should take.

Good luck!

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