News about the $65 billion Ponzi scheme perpetrated by former NASDAQ chairman Bernard Madoff has set off alarms in people’s heads about investment fraud. While Ponzi schemes have been around for nearly a century, people continue to fall prey to the false promises of their promoters.
Ponzi schemes are an old scam named after Charles Ponzi, a swindler from the early 1900s who conned $10 million from investors by promising 40% returns on postage stamps and international mail coupons. The Ponzi scheme, also known as a pyramid scam, works on the “rob Peter to pay Paul” principle. The formula is simple: Money from new investors is used to provide a return to initial investors.
However, the scheme collapses when money owed to previous investors is greater than the money that can be raised by new investors — as was the case with the Madoff fiasco. Once the market declined, investors needed their money and started to withdraw. The whole thing collapsed like a house of cards.
“The problem is that people want above-market level returns and below-level risks at the same time. And those are two incongruent characteristics of the market,” says Ivory L. Johnson, director of financial planning at Scarborough Capital Management in Annapolis, Maryland. “Madoff got a 10% return on his investments year in after year out with no fluctuations. That is very attractive to people, but it is not realistic.”
Two things are at work: fear and greed, says Fred Joseph, Colorado Securities Commissioner and president of the North American Securities Administrators Association (NASAA), headquartered in Washington, D.C. People fear that they will outlive their savings or they greedily want something that promises to pay out a lot of money, he explains. “They are searching for alternative investments to current stock market returns or bank interest rates.”
Ponzi schemes aren’t the only investment frauds, but they do top the list of scam artists taking return-hungry investors to the cleaners, reports the NASAA. A close second is investment fraud targeting seniors. Other schemes include unregistered securities, promissory notes, offshore investing, and charitable gift annuities. Sometimes, there’s no product involved at all; only money exchanges hands. But Ponzis or investment scams, Joseph says, may be tied to a product such as real estate, generic drugs, jewelry, and even gold mines.