What It Is:
A Ponzi scheme is an investment scam that pays existing investors out of money invested by new investors, giving the appearance of earnings and profits where there are none. Ponzi schemes are also known as pyramid schemes.
How It Works/Example:
The Ponzi scheme was named after Charles Ponzi, who organized a large operation to defraud investors (mostly new immigrants). Like most Ponzi schemes, he offered high and consistent returns by using money from new investors to pay off earlier investors. Ponzi went to prison when his operation was uncovered and shut down in 1910.
Ponzi schemes lure investors by promising high returns on their investment. The schemes require the continual attraction of new investors; as soon as new investors fail to materialize, the operation runs out of money and fails.
In 2008, the government uncovered a Ponzi scheme led by financier Bernard Madoff. The scheme defrauded investors of almost $65 billion over a period of 17 years, making it the largest Ponzi scheme fraud in history.
Why It Matters:
Ponzi schemes are fraudulent and illegal in most countries. They may work in the short term, but they inevitably run out of money. Investors need to be skeptical of offers that sound "too good to be true" and should take time to understand how their chosen investment generates profits.