Ask Mint | Why investors fall prey to Ponzi schemes

Ask Mint | Why investors fall prey to Ponzi schemes
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First Published: Sun, Apr 26 2009. 10 50 PM IST

Updated: Sun, Apr 26 2009. 10 50 PM IST
Boom periods are the best time for all sorts of fraudulent merry-go-rounds. When everything is on the upswing, it becomes so easy for con artists to convince gullible investors that anything can be turned into gold. But when the dust finally settles, it becomes apparent that it’s just a round world after all—what we were throwing in the east was coming back to us from the west. Investors have to cry when the biggest investment opportunities turn out to be the biggest Ponzi schemes.
Johnny: It is really very sad to see anybody falling prey to fraud, Jinny. To make investors more careful, can you elaborate a bit more on what the term Ponzi scheme really means?
Jinny: The term Ponzi scheme is used to describe any fraudulent investment scheme that does not generate any actual profit and which pays back investors either by using their own money or by using the money of subsequent investors. The modus operandi is simple—pay Peter by using the money invested by Paul and pay Paul by using the money invested by Mary. It is obvious that such a scheme of paying back one investor by taking money from the other is, sooner or later, bound to fail. But Ponzi schemes may, in fact, succeed in attracting a large number of investors before they fold up.
There could be several reasons for this. First, Ponzi schemes generally flourish when the overall investment climate is good, which makes investors think that this time it is really going to be different. Second, Ponzi schemes do offer something that many investors, high on adrenalin, can’t refuse: a high rate of return matched with consistent performance. To add credibility to such a mouth-watering promise, Ponzi schemes may sound as if they have discovered some secret formula that is not yet publicly accessible.
Early investors of Ponzi schemes are treated like members of an exclusive club where only a lucky few can get in. This acts as an inducement for others to join. Things become merrier with an ever-increasing flow of money from new investors joining every day, which keeps the whole scheme going.
But ironically, the ever-increasing number of investors brings the day of final downfall closer. A day comes when the scheme finally evaporates into thin air.
Illustration: Jayachandran / Mint
Johnny: That’s what you can expect when you have to slay one chicken to feed another. But tell me, Jinny, how did this term Ponzi scheme really become popular?
Jinny: The term Ponzi scheme owes its origin to Charles Ponzi, who emigrated from Italy to the US in 1903. Ponzi operated something that was said to involve arbitrage in International Reply Coupons (IRCs) for postage stamps, a kind of scheme many investors didn’t fully understand. IRCs purchased in one country could be used to get postage stamps in another country. Ponzi discovered an arbitrage opportunity in all this: He could buy IRCs at cheaper rates in Italy and use them to exchange more valuable postal stamps in the US, which could be resold later for a profit.
Many investors could not understand the complexities of Ponzi’s scheme but it surely sounded like something new. Ultimately, many investors willingly took a bite. Initial investors were paid back their money as promised, which attracted even more investors. Ponzi became a master at juggling money from one investor to pay back another, which helped him successfully run the scam.
Ultimately, like any other scheme of this type, Charles Ponzi’s scam ended in the gutter, with many investors losing their shirts. Ponzi, of course, was not the first person to come out with this idea of paying investors by using their own money, but his fraudulent scheme generated so much publicity that the term Ponzi scheme has since continued to remain in public memory.
Johnny: Some terms do become notorious by remaining in public memory. But tell me, what makes investors fall prey to such schemes again and again?
Jinny: Well, that could become a very good topic of research in public psychology. The first problem, I think, is that we often do not like to learn from the mistakes of others. A dog biting others is just bad luck for others. The second problem is that it is really very difficult to identify a Ponzi scheme in advance. Otherwise, why would anybody knowingly put his hand in the mouth of a ferocious dog? New Ponzi schemes are successful in attracting new investors because they always look different.
Moreover, any investment opportunity, good or bad, big or small, can at any time turn into a Ponzi scheme without warning. The mechanism is so simple that any investment manager not meeting the promised return can be tempted to use it.
Johnny: That’s true, Jinny. There could always be a temptation for unscrupulous investment managers to temporarily fool investors. But in the end, Ponzi schemes always bite their own masters.
What: Ponzi schemes pay back investors by using their own money or by using the money of subsequent investors.
Whom: The term Ponzi scheme owes its origin to Charles Ponzi, who operated a fraudulent scheme in the US.
Why: Ponzi schemes ultimately fail because they can’t keep on generating the ever-increasing flow of money required to sustain repayments.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, Apr 26 2009. 10 50 PM IST