Are you looking into side hustles? While we all want to “get rich quick,” if something sounds too good to be true, it just might be. In this article, we'll cover exactly how to avoid Ponzi schemes — faux investment opportunities that will quickly leave your bank balance in the red.
Learning how to spot a scam is important when you’re considering investing your cash.
So let's take a look at how these schemes work, specific examples of them, and detail the red flags you need to be aware of.
First up, what is a Ponzi scheme?
Chances are, you’ve heard the term Ponzi scheme, but do you know what it means?
Ponzi schemes are fake or fraudulent investments that encourage investors to pay into and in turn earn regular returns.
While legit investment schemes offer returns from real profits, the money first investors get back in Ponzi schemes actually comes from subsequent new investors. With the initiator of the scheme raking in the bulk of the investments for themselves.
The hoax takes its name from Charles Ponzi, a Boston-based con man who defrauded investors back in 1920. Since there is no real investment opportunity, to survive, the schemes have to continually attract new investors to provide the returns stream.
A high-level answer to the question, "what is a Ponzi scheme?" is that Ponzi schemes are dangerous. They come crashing down when they can no longer attract new investors. That is when most previous investors will lose their money completely.
With that said, learning how to avoid Ponzi schemes is incredibly important as they can be hard to decipher so keep reading!
Now that you know what a Ponzi scheme is, let’s take a look at a couple of the most famous examples. Here are some of history’s best-known scams:
While Charles Ponzi was not the first person to run a scheme of this nature, the name of such cons comes from him. To attract potential investors, he promised people a 50% profit within the first 45 days of buying in or a 100% profit within the first 90 days.
He claimed that the scheme meant buying discounted postal reply coupons from abroad and then redeeming them in America to exploit the price difference.
However, in reality, he was merely using new investors’ money to pay off older investors.
The former Church of Scientology minister, Reed Slatkin, networked his way to financial gains and robbed 800 clients of almost $600 million in the 1980s.
The con lasted around 15 years and it wasn’t until 2003 that he pleaded guilty to defrauding his list of investors.
Reed Slatkin told potential investors — including his close friends and even movie stars — that he was investing their money.
However, the cash was going directly into the Church of Scientology. Any returns that investors received came from new investors’ pockets.
Bernie Madoff is an American financier who pulled off the largest Ponzi scheme in history to date. Unbelievably, the scam lasted 17 years and he managed to defraud tens of thousands of investors out of around $20 billion.
He attracted investors by claiming to use the “split-strike conversion” which is a legitimate trading strategy. Of course, he was not using this approach at all.
Instead, he was putting all of the investment money into one bank account and using it to pay off old investors.
The money pot soon ran dry when he failed to attract new investors and Madoff was found out. He was sentenced to a massive 150 years in prison and died in prison in 2021.
CEO and chairman of Petters Group Worldwide, Tom Petters, executed a $3.7 billion Ponzi scheme.
Investors believed their funds were buying retail merchandise, generally electrical goods, which would be sold to discount stores at a profit.
However, Petters was not investing any of the money; he was using it for one of two things. Part of the cash went toward funding his lavish lifestyle and the other part went toward paying off new investors. In 2010, he was sentenced to 50 years in prison.
The examples provide insights into Ponzi schemes to avoid. But not to worry, we are going to get into even more detail so you are fully aware!
Ponzi schemes vs. Pyramid schemes
Pyramid schemes and Ponzi schemes have a lot in common — they both lure investors in with false promises and ultimately end in financial loss.
However, there’s one big difference between these two types of schemes, and that is how the income streams work.
Ponzi scheme income structure
With a Ponzi scheme, the high “returns” that investors get come from new investors pouring money into them. However, the investors believe that the returns come from a legitimate source.
For example, they may be led to believe that the funds are being invested in new companies, merchandise, or other forms of trading.
Each time a new investor comes aboard, they are given the same information and told that they will get rich quickly.
Their payments serve as an income stream to pay previous investors. This particular cycle continues until there are no new investors and it crashes.
Pyramid scheme income structure
On the other hand, with pyramid schemes, new investors have to recruit other investors themselves to keep the so-called profits coming in.
Often enough, the focus of these schemes is on building a “team” and recruiting new people to the company. The more people you recruit below you in the pyramid scheme, the more money you will get.
When you have invested in a pyramid scheme, you will earn money by recruiting people. There may be a product that you are all selling.
For instance, you may be selling beauty products, clothing, or nutritional shakes — but the real money comes from new recruits.
How to avoid Ponzi schemes
It literally pays to be vigilant when investing. When an opportunity comes your way promising instant returns, you may be blinded by the light.
It's one thing to understand the question, "what is a Ponzi scheme?". However, if you don’t fully understand the investment and how it works, you should avoid it like the plague.
Luckily, learning how to avoid Ponzi schemes — and knowing what the red flags are — will help you to protect your finances. Let’s take a deep look at what you need to know.
6 Red flags to look out for
Figuring out whether an investment opportunity is legitimate doesn’t have to be hard. You simply have to do your research. To protect yourself from these schemes, you should be wary of the following signs:
1. It’s a “once in a lifetime” opportunity
When the investment representative first reaches out to you, they might tell you that this is a “once in a lifetime” opportunity to become rich.
It sounds too good to be true… and it is. If the person is making big claims that this investment will change your life, be careful what you sign.
2. The allure of high returns
Every investment you make carries an element of risk. There are no shortcuts here. So, when a company is offering you a “low risk” and “high return” package, you need to ask yourself why.
It’s likely that this particular opportunity is not as solid as it first sounds.
3. The promise of consistent returns
Whenever you invest money, your investment will rise and fall. That is natural. Depending on the risk level, you might see some real peaks and extreme lows.
If a company suggests that you can consistently make high returns on a month-by-month basis, that’s a red flag.
Ponzi schemes can offer this level of consistency in the short term. That is because the revenue comes from new investors who join the scheme.
Put simply, the scam is not affected by changes in the market. If that sounds familiar, steer well clear of the con.
4. The company processes are a mystery
Are things shrouded in mystery? While we’re on the topic of transparency, it’s important to understand how the investment process works.
If the investment representative offering you this opportunity says that the strategy is “complex” or “secret,” you might want to run for the hills and avoid this Ponzi scheme.
If you’ve asked for more details about how the system works and the rep is being shady, that should be enough for you to back out. Protect yourself and your finances.
5. You are pressured to make a decision
If the representative is constantly asking you to make a decision, you have to wonder what the hurry is all about.
Often, Ponzi scammers will use this tactic to coerce people into making poor decisions. When there is a time limit on your investment, you need to wonder why that is.
6. You’re not getting paid on time
Should you have already joined the scheme, be wary if you struggle to “cash out”. If there's always a suspicious reason that you can’t get your returns, that may be a red flag.
While technological problems do arise from time to time, you need to be cautious.
How to report a Ponzi scheme
It’s not simply about learning how to avoid Ponzi schemes. These scams damage people’s finances and can ruin their lives. For that reason, you should always report them.
It doesn’t have to take too long, either. You can go online to report fraudulent schemes to the local government or the federal government.
Make sure you have as many details about the Ponzi scheme as possible before you start as you will need them.
Aside from the governmental routes, you can also report the scheme to one of the many fraud investigators.
These professionals may be able to look into the claim, offer solid expert-backed advice, and investigate the priority level of the investment fraud:
- Internet Crime Complaint Center
- U.S. Commodity Futures Trading Commission
- U.S. Securities and Exchange Commission
When you have submitted your initial report, make sure that you follow up. Whether you have been affected by the scam or otherwise, it pays to make sure you get some results.
Recognize the signs and avoid these schemes!
Now you have key information on how to avoid Ponzi schemes as well as tips on how to identify the signs. Remember, investing is rarely ever a guaranteed quick and easy route to extra income.
If someone out there is telling you otherwise, they may be trying to scam you. Whenever you’re considering an investment, make sure that you look out for the red flags that we have listed.
Finally, be sure to leverage our free courses to learn exactly how investing works the legit way!