Definitions Deconstructed

Definition:

Ponzi Scheme = An investment swindle in which some early investors are paid off with money put up by later ones in order to encourage more and bigger risks. [REF]

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Deconstruction:

Though not exactly the same as the more well-known pyramid scheme, in both instances, the ploy only works while new participants are coming on board to support the investors higher up in the chain.  When the inflow of new capital dries up, the entire operation unravels.  As a result, the key to maintaining this ruse is soliciting and engaging new depositors.

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The Ponzi Scheme is named after Charles Ponzi, based on his fraudulent investment company created in Boston in 1919.  However, the strategy was actually conceived in the mid 1800’s, separately, by a pair of enterprising women, in Germany and the United States.

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Charles Ponzi, like many entrepreneurs, started with a legitimate business idea, running an arbitrage on postal coupons between the United States and Europe based on fluctuating currency rates.  Amusingly, the ineptitude and borderline insolvency of the U.S. Postal Service continues today, over a century later.

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Ponzi promised people they could earn a 50% return on their money in 3 months.  Initial investors achieved this absurd interest rate, since Ponzi was simply paying out the distributions from the growing pool of incoming money.  Obviously, this strategy only worked as long as new marks were joining in.  

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In such scams, the charisma and skill of the con artist is vital.  In this regard, Ponzi was very adept at his craft, luring in thousands of Bostonian residents from all walks of life, while gaining notoriety and accolades in the local tabloids, right up to the demise of the entire investment scheme.

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Unsurprisingly, this dog and pony show lasted less than a year, but was broad in scope, covering most of the Eastern United States.  In just 8 months’ time, the operation brought in over $20 million dollars, equivalent to more than 10 times that amount today due to inflation.  The immense loses incurred by enamored, unwitting speculators were memorable enough to cement this lexicon into investing lore.

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Ironically, Charles Ponzi called his made-up company the Securities Exchange Company, which shares the same SEC acronym as the U.S. governmental bureau now tasked with sniffing out this kind of fraud.  

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Despite occurring a century ago, the Ponzi Scheme approach is still used for exploitation, on both local and national levels.  The ploy is so prevalent in investing circles that several additional terms have been developed over the years to describe the technique.

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“Borrow from Peter to pay Paul.”
“Pump and dump.”
“Greater fool theory.”

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All these sayings can be attributed to Ponzi’s enterprising, albeit illegitimate, business venture.  A few of the more well-known pyramid scheme occurrences in recent times are as follows.

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• Bernie Madoff represents the ultimate Ponzi Scheme of the modern age.  He compiled over $17 billion in assets, much raised from prominent athletes (Sandy Kofax), celebrities (Kyra Sedgwick), and public figures (Larry King), along with numerous charity organizations.  Madoff’s brilliance was based on not promising unreasonable returns, just incredibly attractive investment results, with a sly sales pitch to back them up.  The 2008 financial crash exposed the fragility of the scam, and landed Madoff a 150-year prison sentence, which he serving out until his death in 2021, despite numerous judicial pleas.

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• Creativity is important when coming up with believable scams.  In that regard, Arlan Galbraith’s ploy may take the cake.  Between 2004 and 2008, he targeted highly religious groups in Canada, encouraging them to raise pigeons, initially for racing, then as a high-end restaurant protein.  Making up each bird’s lineage, he would then sell certain pigeons back to the unsuspecting farmers, with the promise of desirable physical traits, and future purchasing contracts.  Galbraith was able to secure over $40 million before his organization, dubbed Pigeon King International.  Confusingly, Galbraith ended up broke, with over 40,000 pigeons in his Ontario barns, suggesting a lack of understanding on how the scheme was supposed to play out.

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• Here’s one that likely touched a lot of people throughout America.  In 2005, MonaVie, was founded in Utah.  Within a few years, this multi-level marketing system had expanded rapidly.  Controversy abounded regarding the heath benefits of the fruit blends in the drink, the absurd returns average citizens claimed to be making selling the product, and the viability of the business plan in general.  After a good early run, 10 years later, MonaVie went into foreclosure after defaulting on over $180 million in loans.  Undoubtably, a few bottles of this magic purple drink are still floating around in people’s basements.  

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• The current avenue for financial fraud is in the cryptocurrency space.  Most notably is BitConnect’s online investment scam, which ran from 2016 to 2018, achieving a peak market cap of $2.6 billion.  The company promised 1% daily compounding on investments, an absurd return which was a siren’s song to many naive participants just entering the digital coinage landscape.  When the BitConnect platform suddenly closed due to regulatory pressure, their coin value dropped 95% within minutes.  Armed with the power of the internet, this most recent generation of Ponzi Scheme imitators operated in physical anonymity, accepting investment money with no underlying business case or asset value.

 

The best way to spot a scam is if it sounds, or looks, too good to be true.  Complexity, excess returns, illiquidity, lack of transparency, guaranteed consistency, and minimal regulation, are all signs of a potential fraud.  These same tactics can work well for prioritizing your human relationships as well as your investments. 

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Ponzo and Ponzi, the descriptive monikers attached to the two seemingly unrelated concepts discussed above, are similar in spelling, since both are named after gentlemen born in Italy.  However, these disjointed topics actually have several other traits in common: a similar date of origin, a deceptive nature, and a reliance on angularity.  Ironically, the same approach works for understanding illusions and analyzing investments.  

 

Make sure to check all the angles out there; they often conspire towards trickery.  If your skeptical, just check out the final diagram below.