What Is a Ponzi Scheme?

The Ponzi scheme is often mistaken for, or confused with a pyramid scheme, and while they have the same structure, they don't operate the same way.

A pyramid scheme is based on selling something intangible like an idea, a secret to making money, or other non-existent programs. One person sells their idea to six people for a fixed fee. Those people are then free to sell to as many people each as they want, charging their own fee. The "pyramid" expands until there is virtually no market left, and the structure collapses.

A Ponzi scheme typically involves investments or financial transactions of some sort. The name originated with Charles Ponzi, who immigrated from Italy to the U.S. in 1903. Once here, he began running the schemes to fellow immigrants who had little knowledge of the country or the language, and were easily taken in.

For example, the pitch may involve something such as an investment with very complicated explanations and terms, but the bottom line is that you will earn 25% back in 60 days. The more you invest, the more you earn. A pitch has to be relatively slick today, with lots of information, even if it's false, and demonstrations as to how the investment will be returned, grow with time, etc. In pyramid schemes you don't get this type of information up front.

What actually happens is something like this. Ten investors each sink $5,000 in the plan. Meanwhile the salesman is recruiting new investors and getting their money as well. In 60 days, the person who runs the Ponzi, pays back to those first ten investors, $1250 plus their original investment. But he didn't actually earn that money on anything. It is taken from the next group of investors and passed back along the line.

Where the profits are made, is from the first levels of investors, who see their money increasing and leave it in the "kitty", getting back a 25% in 60 days, and so on. Eventually they find out, there was no kitty.

Ponzis usually fall apart when someone blows the whistle, the originator takes off with all the money, or investments have slowed to the point where they can't pay the returns of the upper level investors.
 

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