What a Ponzi Scheme is and How to Avoid Becoming a Victim of Such Financial Fraud

Anyone who has turned on the news as of late has heard of the huge financial fraud perpetrated by a man named Bernard Madoff. Madoff ran a "Ponzi Scheme" and bilked investors out of more than $50 billion. Like any other Ponzi Scheme, Madoff offered his investors returns too good to be true. But just what is a Ponzi Scheme and how can you avoid becoming a victim of one?

A Ponzi Scheme, named after early 1900's scammer Charles Ponzi, is a fraudulent investment operation that pays interest to its existing investors with the inflowing money of new investors, rather than form profit. The so called investment operation will fool investors into thinking that they are a legitimate entity that has a way to offer huge returns. The schemers often rely on the ignorance of investors and will use big terms such as "global currency arbitrage", "hedge futures trading", "high-yield investment programs" or "offshore investment" just to sound more sophisticated and legitimate. The scheme though will eventually collapse and be exposed for what it is, a fraud, and usually leaves its investors high and dry (and broke) in the process (source: wikipedia.org).

Here's how it works. The investment operation will promise investors an unrealistic return for their money; say 25% in one month's time. With no track record, the schemers will at first get very few investors. But after a month when the investors get back there principal plus the huge interest payment, the schemers will often offer a second investment opportunity at an even higher return. With the success of the first investment, most investors are more than willing to give their initial investment back plus more. In the meantime, word spreads and investors begin to flock in and look to be involved in such a great investment opportunity. Now the company needs only send out "interest" payments and statements showing that the investor's principal is safe. The schemers will sometimes even offer more of a return if the interest is left in the account instead of distributed. On paper everything looks on the up and up and the investor thinks he or she is making a mint (source: wikipedia.org). But eventually one of three things will happen.

The most likely scenario is that the scheme will collapse under its own weight, as investment slows and the scammers start having problems paying out the promised returns. When the schemers start having problems with interest payments, the word spreads and more people start asking for their money thus leading to the exposure of the Ponzi Scheme (source: wikipedia.org).

It is often the first scenario that occurs that can lead to the second scenario occurring. Investors will begin to complain to authorities and after many complaints; the authorities will uncover the fraud. The only problem is that once the fraud is uncovered there is usually little to no money to be recovered for the investors (source: wikipedia.org).

The third scenario is that the schemers will simply pack up and leave with any remaining money. Many times when the heat starts getting to be too much, the scammers will simply disappear only to resurface in some other part of the country with a brand new Ponzi Scheme for more unsuspecting victims (source: wikipedia.org).

So the question is how do you avoid becoming a victim of such financial fraud? The golden rule in life and certainly in investing, is that if it sounds too good to be true, that is usually because it is. Be wary of offers of returns that are out of this world and ask questions. Scammers are getting more and craftier and remember they rely on the ignorance of others. Ask to see a prospectus and examine it thoroughly. If you do not know what someone is talking about or can't understand what you are reading in the prospectus consult a professional (or two or three). Bottom line, if you don't feel comfortable with the investment, do not do it. Be one your toes and use your financial advisor if need be, but don't fall victim to the every growing problem of Ponzi Schemes.