How to Identify Ponzi Schemes and Avoid Them

Ponzi Schemes
Reading Time: 9 minutes


In 2019 US federal and state authorities identified roughly 60 active ponzi schemes with investors funds estimated at $3.5 billion. The largest within the last decade.   There’s therefore a growing concern that there may soon be a massive burst.

This post explains how to identify ponzi schemes and it is intended to guide those who do not want to get scammed by fraudulent investment schemes that are springing up in all corners of the earth.  

What Is a Ponzi Scheme? 

Ponzi Scheme is often a fraudulent investment offering.  The operator pays agreed returns from the investment of new clients rather than from profits generated from an underlying business.

As a matter of fact, ponzi schemes often have no underlying businesses that genuinely earn revenue; hence they depend on new investors to fulfill their obligations to existing investors.  As soon as their capacity to attract new money  reduces,  the scheme collapses.  And those who were unfortunate to not have cashed out by this time would have their investment trapped.  

As long as new people keep joining the schemes, both the operators and their patrons will keep enjoying the party. 

Ponzi Scheme is named after Charles Ponzi.  This man was an Italian immigrant in the United States who pulled what has come to be regarded as one of the greatest fraudulent investment schemes in history.  In 1920 in Boston, Charles Ponzi floated a scheme which promised 100% ROI in 90 days.  At that time average rate of return was about 5% per annum.

When the scheme collapsed, it was found that Charles Ponzi’s claim to dealing on International Reply Coupon (IRC) was a scam. He merely paid old investors with new investors’ money.  About $7 million of investors’ money was lost to the scheme. 

He pleaded guilty to mail fraud, was jailed for 14 years and earned a his notorious place in history. 

Ponzi Schemes vs Pyramid Schemes

Ponzi schemes and Pyramid Schemes have similar characteristics.  They are both based on the same concept in that they rely on new patrons to continue to exist.  

Whereas in a Ponzi, the bait is the often extraordinary returns on investment that the promoter promises; a pyramid scheme rewards its patrons strictly on the basis of recruitment of new members. 

The difference then is that Ponzi Schemes are often investment offerings. But a Pyramid scheme’s major offering is the recruitment of down lines and payment of bonuses. The more people a member recruits, the higher he climbs on the pyramid.

Pyramid schemes have two main elements: payment of an upfront fee to join the scheme with a promise of a huge payout within the shortest possible time.  And a compulsory obligation to recruit at least two additional people to join the scheme who also in turn pay the upfront fee.  And so it goes.

Thus, the promoter tells you that all you have to do is join a certain business with a small amount of money, say $500.  Then you have to bring in two people who also have to join the business with the same amount each.  Those two you recruited will also need to recruit two of their own.

You get $3,000 in 4 weeks. That’s 6x your investment in one month!  You did not sell anything or rendered any service for your 600% ROI in four weeks.  Sweet isn’t it?

Nowadays, ingenious Ponzi schemes operators are also adopting the pyramid model to make their schemes even more attractive.   Such schemes in addition to offering mouth watering returns on investment also incentivises investors with bonuses to introduce new investors into the scheme in a manner similar to a typical pyramid scheme.

The juicy story then is they open two high income revenue streams to you.  You earn the high ROI on your investment, in addition to referral bonuses in the network you are able to create. 

The common element here is that both the Pyramid scheme and Ponzi scheme are fraudulent.  They often collapse due to lack of a sustainable business model.  And their customers lose money heavily when they do. 

Ponzi Scheme vs Network Marketing 

It’s common to bring network marketing in the mix of these fraudulent businesses.  Why?  Because network marketing also operate based on the pyramid model.

Also known as Multi-level Marketing (MLM),  Network marketing is a direct marketing strategy.  It uses a network of individuals to sell products or services directly to consumers.  Network marketing is beneficial to both the product owner and the individual net worker.   To the product owner it reduce cost of distribution, promotion and advertising.  

The individual on the other hand enjoys the benefit of leveraging on an organised platform to start a business with little capital.

Network Marketing adopts the pyramid strategy in managing and compensating its distributors.   That’s why some people confuse it for pyramid schemes.   It’s not.  But the bad reputation of fraudulent pyramid schemes is rubbing off on Network marketing.

Network marketing has been endorsed by very prominent individuals as a sound business model.  Indeed, Robert Kiyosaki, the author of the best seller, Rich Dad, Poor Dad; described networking marketing as the business of the 21st century.

How to identify Ponzi Schemes

The form and shape of ponzi schemes are as many as there are fraudulent minds.  They are only limited by the ingenuity or imagination of the individual promoter.  The common factor in all of them is that the promoter and early investors make the most money.  Those who join late bear the greatest risk.

Every Ponzi or fraudulent investment scheme has a red flag. Here are a few of them:

#1. Promise of extraordinary  returns:  “If it’s too good to be true, it probably is”, is a popular adage. Conventional investment schemes offer returns that are within reasonable band of benchmark interest rates.  So when someone presents an opportunity that offers abnormal returns; question it.   Ask him to tell you what business he is doing to generate that level of returns.

Ponzi Scheme operators often use guaranteed returns as a bait to hook the gullible and greedy.  Except for government securities such as sovereign bonds and treasury bills, no investment  is ever guaranteed.

#2. Boasts of not making any losses  – Operators of ponzi schemes will always boast of making consistent high income on their trades.  This is not possible.  Financial markets are volatile and nothing can be certain.

#3. Unlicensed Operator – When considering to invest in any scheme, check out the operator and the scheme itself.  Is the firm registered or does the person promoting the scheme licensed to offer that type of investment? It is a red flag for an unregistered operator to solicit funds from the investing public. 

#4. Pressure to invest –  Promoters of fraudulent investment schemes market their products with uncommon zeal and aggressiveness.  This is because they are very much aware that their scheme will collapse if there is a dearth of new investment or customers.

To keep the wheel running, they employ all tactics to continually get more people into the scheme. Some of these tactics may include persistent phone calls, unsolicited bulk emails, etc.  They may also employ the pyramid strategy and give referral incentives.

There’s that urgency to act now. When you are under such pressure to make an investment now  It is a red flag; sit back and take a second look at the proposals.  

#5. The business model is not clear –  Every genuine investment scheme is based on an underlying activity or project.  If you cannot describe the business model of any investment proposition, it is a warning sign clearly written.

Avoid investing in activities you don’t understand no matter how alluring.

Why Ponzi Schemes Thrive

It is over a century since Charles Ponzi shook corporate America with his fraudulent investment scheme.  Yet such schemes still thrive with an endless list of victims.  In 2008, the story broke of Benard Madoff who ran the biggest ponzi scheme in history so far.  His $65 billion investment scam collapsed in the midst of the raging financial crisis then with thousands of investors affected.

Ever wondered why in spite of common experiences and the high number of people who lose money to fraudulent investment schemes, Ponzi investment still thrives?  The truth is that more and more people are willing to take unnecessary risks.

In my interaction with both patrons and victims, people continue to invest in ponzi schemes due to these reasons:

#1. Greed – The single most common reason why an increasing number of people still fall prey to ponzi schemes is personal greed.  A lot of people want to earn abnormal returns on small investments within a short period of time. They want to double their money with little effort.

Ponzi Scheme operators understand how the average human mind thinks when it comes to making money decisions and they capitalize on this understanding.

#2. Gullibility – In spite of massive negative publicity with Ponzi schemes attract, many people still display gullible behaviours and allow themselves to be sweet talked into taking part in phoney investment offerings. 

Some researchers have propounded a theory of gullibility as to explain the success of ponzi schemes.  These researchers defined gullibility as a sub-type of foolishness.  Foolishness being a situation where  

“someone goes ahead with a socially or physically risky behavior inspite of danger signs, or unresolved questions which should have been a source of concern for the actor (Greenspan, 2009).”

#3. Low returns in the conventional investment market – The world has not really recovered from the impact of the global financial crisis which happened in 2017.  Except in a very few cases, stock markets around the world still struggle and the fiscal and monetary authorities in many countries are still dealing with responses to imbalances in the macro-economy.

In places like Nigeria, return on Treasury Bills is at 3% while inflation prints in double digits above 12%.  Conditions like these discourage investment in conventional instruments and since money must go where the returns are high, ponzi’s become attractive.

#4. Addiction to easy money – Yes, there are people who are addicted to easy money. They are constantly looking out for opportunities to double, sometimes triple their money.  Such people are probably born gamblers.  No amount of negative commentary will stop them from patronising ponzi schemes.

#5. Insufficient investing knowledge – While some have developed a thick skin for fraudulent investment schemes, the majority of other people lack sufficient knowledge to make rational choices. These category of people are gullible and easily fall to unrealistic projections about ROI.

Legitimate Investment Schemes Also Fail

I have heard some argue that even legitimate investments also do fail.  It’s often a justification for their attraction to Ponzi schemes.

A few years back, patrons of MMM advanced arguments like these.  The scheme eventually collapsed before they knew it and many lost their life savings.

Generally, any type of investment has an element of risk but the risk in legitimate investment is calculated.  Events like market burble as it happened in 2007 can cause a major crisis in the financial market and make investors lose money.

However, burbles don’t just happen.  It builds up and discerning investors will always see it coming.  They could mitigate its impact by adopting suitable risk management strategies.

This is unlike Ponzi where failure is certain.  The only thing uncertain in Ponzi Schemes is that no one can accurately predict when the scheme will collapse or who will get hurt.  Investing in schemes promoted by registered operators comes with a lot of advantages.  Regulation ensures that the promoters act within a defined boundary.

Most importantly, even when a legitimate investment fails, the investor will not lose everything.  There often statutorily prescribed measures to protect investors in a legitimate scheme. This can be in the form of deposit insurance, investor protection fund or government bailout, etc.

An aggrieved investor in a registered investment scheme can petition the operator for wrong doing.   And even recover his investment plus cost through the exploitation of legal actions.

How to avoid ponzi schemes

Now you know you know how to identify ponzi schemes. How can you avoid it?  What do you need to do to ensure that you don’t fall victim of an investment fraud?  

Here’s what you must do if you do not want your retirement benefit to vanish in the hands of fraudulent investment promoters:

#1. Entrust your money with only legitimate, authorized and approved investment firms.  Every country has an agency vested with the responsibility of ensuring sanity in the financial markets.  These agencies vet, approve and register operators.

The agency with this responsibility in most countries is the Securities and Exchange Commission or the financial services authority in some other countries.  Find out how it runs in your country.

#2. Do your due diligence – Before investing money or giving your money to anyone to manage and pay you returns; conduct your research.  Find out out important things about the promoter.  Is he authorized to do the business of investing? What is his track record? What are people saying about the business? etc.

#3. Understand the Investment Programme – Many people invest in what they know little or nothing about.  Why you don’t have to be an expert in everything, it pays to ask some question and understand the general framework of any investment you want to make.

Where in doubt, contact an approved financial advisor, an accountant or a lawyer to help you review the investment programme and give you his professional opinion.  Do not be in a hurry to make an investment no matter how sweet it looks.  You may be under pressure to invest now or lose some benefits, do not buckle under such pressure. Take your time, there will always be other opportunities.

#4. Who is in ultimate custody of the funds – Some of the firms that come to you to solicit funds may not be the custodian of the funds.  In the securities industries, there are different kinds of operators.  There are those licensed to receive and manage funds and there others who are approved primarily to render advisory roles.

However, you find that both a custodian and an adviser go out soliciting for funds.  If you give your money to an adviser to manage and he losses it, you may not get a relief.

You are better off entrusting your fund with an authorized fund manager who is under the regulation of the Securities and Exchange Commission or the Financial Industry Regulatory Authority as the case may be.  That way your funds is covered by the Investors’ Protection Fund.

#4. Don’t be greedy – Greed is the chief reason most people patronize ponzi schemes.  They want to make the most out of their money.  There’s nothing wrong with that but you should know when an expectation is unrealistic.

#5. Don’t get carried away – As said earlier, watch out for abnormal returns. It is usually a bait. 

If you are retiree, avoid bullish expectations and simply keep your money in a  interest yielding instruments with minimal risk.  Such instruments pay you on regular basis and, that will keep up with your expenses. Fortunately, the money market offer you such investing opportunities.

Final Words

All investments come with some risks.  But it’s better to take calculated risks in conventional and legitimate vehicles than gamble in ponzi schemes.  Again, investing is a long term activity that requires knowledge, processes and above all patience.  Chasing easy money is nothing but gambling.

Related: The Ultimate Beginner’s Guide to Investing

Decide which is best for you.  Invest methodically and wisely or gamble.


Buchi creates content and leads the Team at Kobotalk Management Services; a business development and investment consultancy firm. He provides strategic advisory to help SME's, small business owners and HNI's grow profitable business and make informed investing decisions.

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