What is a Ponzi scheme and how does it work?

A Ponzi scheme is a fraudulent investment scam where returns are paid to earlier investors using the capital from new investors, rather than from legitimate profits. The scheme relies on a continuous influx of new participants to provide returns to older ones. It typically promises high returns with little or no risk, which makes it appealing to unsuspecting investors.

How does a Ponzi scheme work? 

• Recruitment of investors
  The scheme operator convinces people to invest by promising unusually high returns.
  
  
• Paying returns to early investors
  Instead of generating profits through legitimate business activities, the operator uses the money from new investors to pay earlier investors, creating the illusion of a successful and profitable business.
  
  
• Collapse
  The scheme requires a constant flow of new investors to keep operating. Once recruitment slows or stops, the operator can no longer pay returns, causing the scheme to collapse, and most investors lose their money.

The scheme is named after Charles Ponzi, who became infamous for using this technique in the early 20th century. Ponzi schemes are illegal and unsustainable because they eventually run out of new investors.

The common characteristics of a Ponzi scheme can be found below:

• High returns with little or no risk
  Every investment carries some degree of risk, and investments yielding higher returns typically involve more risk. Be highly suspicious of any “guaranteed” investment opportunity.
  
  
• Overly consistent returns
  Investments tend to go up and down over time. Be skeptical about an investment that regularly generates positive returns regardless of overall market conditions.
  
  
• Unregistered investments
  Ponzi schemes typically involve investments that are not registered with the SEC or with state regulators. Registration is important because it provides investors with access to information about the company’s management, products, services, and finances.
  
  
• Unlicensed sellers
  Federal and state securities laws require investment professionals and firms to be licensed or registered. Most Ponzi schemes involve unlicensed individuals or unregistered firms.
  
  
• Secretive, complex strategies
  Avoid investments if you don’t understand them or can’t get complete information about them.
  
  
• Issues with paperwork
  Account statement errors may be a sign that funds are not being invested as promised.
  
  
• Difficulty receiving payments
  Be suspicious if you do not receive a payment or have difficulty cashing out. Ponzi scheme promoters sometimes try to prevent participants from cashing out by offering even higher returns for staying in the Ponzi.

More information can be found on the website of the US Securities and Exchange Commission.