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Ponzi scheme

"Research shows that three characteristics are related to persuasiveness: perceived authority, honesty, and likeability." --Robert Levine

A Ponzi scheme is a fraudulent scam named after Charles Ponzi (1882-1949). Mr. Ponzi defrauded people by getting them to invest in a bogus product for a guaranteed rate of return and using the money of later investors to pay off the earlier ones. Who will make money from such a scheme? Those who start it and those who get in early. Does anyone really make money from these schemes. They must or they would have died off long ago.

How does one make money in a Ponzi scheme? If I start the scheme, I just skim off the top of my investment collections and pay off (or let people think I am paying off) investors at regular intervals from the money I collect from new investors. I might even be stupid enough to think that I can keep the scheme going when the recruiting has dried up. I can try to get money quickly by some other scheme, like investing in a can't-miss stock my broker recommends. Or I can take a safer route and put a big chunk of money on the craps table in Las Vegas and hope to hit it big. That's what a fellow I played Little League Baseball with did when he grew up. He took his investors' money to the craps table where he "invested" their funds. Unfortunately, his "investments" didn't pay off, his scheme was discovered, and he went to prison.

Ponzi started in the Boston area in 1919 with a loan of $200 and 16 investors who put in under $1,000. In les than six months he had thousands of investors and about $10,000,000. He said he was paying 50% interest on short-term investments. He told people he was buying international exchange coupons in foreign countries and getting six times their value in U.S. postage stamps. Buy low, sell high: isn't that what investment is all about? He claimed he was paying friends who invested with him $150 for each $100 invested and that he was doing this in forty-five days, even though he was promising them payment in ninety days. Why not buy the coupons yourself and skip the middleman? That would be greedy, wouldn't it? Besides, it would take effort on the investor's part. Ponzi would do all the work and the investor would enjoy an obscene profit for doing nothing. It didn't take long before he had so much money coming in that he had to move it from under his mattress to a traditional banking institution, which came under scrutiny and led to his undoing. Maybe investors should be careful when someone promises to make them rich and do all the work for them as well. (It's probably not a bad idea to ask yourself why a total stranger would want to make you rich while you do nothing but give him money.)

There were no postal coupons. Ponzi was paying early birds with the money he swindled out of newcomers. It wasn't long before Ponzi had no investors and free room and board in a federal prison for the next five years. Unlike many others who are defrauded, Ponzi's investors could not claim that he had a stellar reputation for honesty and was certainly trustworthy. He was an ex-convict who had immigrated from Italy via Canada where he had served three years for forgery. He was arrested for smuggling aliens into the United States within a few days of his release from the Canadian prison and then served time in Atlanta for the smuggling rap.

I don't know how many people lost money "investing" in my Little League buddy's scheme, but it could not have been as bad as what happened in Romania in 1993, in Albania in 1997, and Columbia in 2008. In each case, thousands of people with little opportunity for investment of capital were swindled by pyramid scheme operators. Romania's newspapers claimed that millions of Romanians lost their life savings in a scheme called Caritas. Reports from Albania claim that hundreds of thousands of Albanians "have invested their life savings or money they earned working abroad" in one of several outlawed pyramid schemes. "The schemes offered very high interest rates, with the first investors paid from later investors' deposits. They eventually failed when no new investors came in" (Dhimgjoka 1977). A similar fraud left thousands of Columbians with empty pockets a decade later. Any such scheme is doomed to fail because there cannot be an endless line of "investors." Only greed and self-deception are endless.

What causes intelligent people to lose fortunes in Ponzi schemes? I think the main factors are the same ones that cause people to be conned in general: trust and greed. If a crook is not seen as a crook, but as authoritative and honest, people will tend to trust him. Being the head of NASDAQ, a minister in a church, the head of a corporation, an officer in a reputable lending institution, or a police officer impresses people. Your position makes many people trust you. If you appear honest, people will trust you. It doesn't matter that you are dishonest; all that matters is how you appear to others. Above all, if you are a likeable fellow in a position of power with a reputation for honesty, you are in a position to con even the greatest skeptics if they are greedy, ignorant, and lazy. If you have expertise in a complex field and your marks don't, your advantage multiplies. Being physically attractive is a bonus, too. With your qualities and their neediness, you have the perfect recipe for ensuring that your marks will not investigate your scheme too carefully, especially if your field is governed by a labyrinth of laws and regulations. They want you to be who you say you are so much that they will cut you a lot of slack, especially since it relieves them of the burden of thinking too much about what you are proposing. Even though your scheme sounds too good to be true, your marks will give you a pass and will not investigate you thoroughly before handing over their life savings. You're not only selling them a scheme that will make them rich, you're selling them hope and giving them time to spend on their work or other activities without having to worry about their investments. You're banking on their laziness, ignorance, and greed to make you rich, while they perceive you as a hardworking, generous benefactor or as a genius who knows how to beat the market consistently.

See also pyramid scheme and chain letter.

See my review of Three Powerful Books on Persuasion

further reading

book and articles

Zuckoff, Mitchell (2005). Ponzi’s Scheme: The True Story of a Financial Legend. Random House.

New Pyramid Schemes Are as American as Apple Pie: How President Grant was taken by the Madoff of his day by John Steele Gordon

New The Rise and Fall of Albania's Pyramid Schemes by Christopher Jarvis

Impostors, Pretenders and Deceivers What gives liars away? by Loren Pankratz, Ph.D.

websites

Charles K. Ponzi Website

Caritas (Romania)

news stories