Money is a human invention that acts as a medium of exchange and a store of value. It lets us easily carry around our assets in the form of paper, or nowadays, on a card. But because of its characteristics, money allows for some very intricate, complicated con schemes. One famous example is the Ponzi scheme – a type of investment scam.
In 1920, Charles Ponzi had a great idea. Back then, people would send an international reply coupon along with international mail so the receiver could send a reply using the coupon. Ponzi noted that since the value of these coupons were constant across nations, buying it cheap in one country then selling them in the United States would lead to profit. To kickstart his business idea, he began gathering investors, to whom he promised large returns that the investors could not refuse. However, when Ponzi began trading the coupons, he quickly found that it was not effective and he did not make the profit he expected. But instead of telling the investors that his plan failed and that they would not get the returns he promised, he decided to try something different.
Having not heard of Ponzi’s failure, new excited investors asked Ponzi to invest their savings too. Ponzi used the invested funds to pay off the original investors by redistributing the money. Happy that they got their promised returns, the original investors told their friends and family about the incredible opportunity. This brought more new investors to Ponzi, whose money he used to pay off the previous investors. Because Ponzi took a commission from each investment, he quickly raked in a massive amount of money – just by redistributing money around and not actually investing a single cent.
But Ponzi schemes do not last. Eventually, the amount of new investments were not enough to pay off the previous investors and people began investigating, only to discover that Ponzi was scamming them all along.
The Ponzi scheme relies on three things: enticing investors with the promise of high returns, intricate redistribution of money to feed the previous group of investors and the good reputation built through word of mouth. Because the scheme relies on paying old investors with money taken from new investors, a larger number of new investors is needed compared to the old investors. This leads to the formation of a pyramid. When the number of new investors is not enough, for example during a recession, the pyramid’s base becomes weak and the whole scheme collapses, with everyone losing money except for the schemer and the few original investors.
(Click Read More for diagram explaining a Ponzi scheme)
(Image source: http://browse.deviantart.com/art/Support-83476199)