Named after Charles Ponzi, who infamously bilked investors out of millions of dollars in the 1920s, a Ponzi scheme is an investment scam that involves the payment of abnormally high "returns" to investors that are actually paid from money contributed by newer investors. While it's possible that a Ponzi scheme may involve some real investment, the distinction between a legitimate investment and a Ponzi scheme is that, in a Ponzi scheme, some of the returns are not from legitimate investments, but are merely a transfer of money from new investors to earlier investors.
Much like a pyramid scheme, this type of investment scheme depends on the recruitment of a sufficient number of new investors to pay high returns to older investors. At some point the stream of new recruits stops growing and this leads to the collapse of the scheme.
While some Ponzi schemes may be sufficiently sophisticated that even the most cautious investors may be duped, there are certain characteristics one can look for in many Ponzi schemes: (1) promises of high returns with little or no risk; (2) unclear investments about which there is limited information; (3) and restricted access to assets. Often, Ponzi scheme operators will offer investors even more favorable returns if the investors agree not to withdraw their cash.
In a well-publicized case, Bernie Madoff was in 2009 sentenced to a 150-year prison term for carrying out one of the largest Ponzi schemes in history.
For more information, see:
- Securities and Exchange Commission (SEC): general information about Ponzi schemes, including common warning signs.
- Biography.com: a brief history of Charles Ponzi and his eponymous scheme.
- Biography.com: a brief history of the Ponzi scheme carried out by Bernie Madoff.