Imagine the shock, the horror, and the sheer panic that would come with learning that the financial plan you鈥檇 sunk your life savings into was a sham, the financial experts you trusted were crooks, and all your money was gone.
Thousands of investors experienced that nightmare scenario in December 2008, when Bernard 鈥淏ernie鈥� Madoff, CEO of the prominent Wall Street firm Bernard L. Madoff Investment Securities LLC, confessed that the asset management arm of his firm was 鈥渁 total lie,鈥� as he put it. An estimated $65 billion of investors鈥� money vaporized in the financial fraud that experts call a Ponzi Scheme. So how does such a scheme work, and how did Madoff trick so many people?
The Ponzi premise is simple, said Ed Ketz, an associate professor of accounting at Penn State. Ponzi victims -- typically those without in-depth knowledge of financial jargon -- are lured by the promise of fantastic returns on their money. Impressive-sounding terms such as "hedge futures trading," "high-yield investment programs," and "offshore investment" are bandied about, but in reality, the dividends paid to investors don鈥檛 come from prudent analysis of the markets. Instead, Ponzi payouts come from the cash deposited by other investors.
鈥淚t鈥檚 a charade to get new investments to feed the previous investors and further enrich the person carrying out the scam,鈥� Ketz said.
As long as new investors continue to inject cash, existing investors receive their dividends and have no reason to suspect foul play. However, when the economy slows down, the scam unravels, Ketz said. New investors stop investing and old investors want to withdraw their funds; that鈥檚 when people realize there is nothing to withdraw.
Madoff apparently began his scheme in the 1990s. He claimed then to have devised a proprietary investment strategy he called 鈥渟plit-strike conversion,鈥� when, in fact, he was simply depositing his clients鈥� money into his Chase Manhattan account.
The Ponzi ruse isn鈥檛 a new idea. This type of financial fraud is named for Charles Ponzi, a 鈥渃onfidence trickster鈥� (the origin of the phrase con man) who fleeced New England investors in the 1920s. Before that, a similar scam was outlined in Charles Dickens鈥� 1857 novel, "Little Dorrit."
So, if the Ponzi Scheme has been around for so long, why do people still fall for it?
It鈥檚 all about trust and the potent lure of easy money, Ketz said. Madoff鈥檚 investors thought they were being allowed access to lucrative investment secrets.
鈥淧eople, even smart people, can be fooled by such schemes because they are drawn in by those who seem smart and experienced,鈥� he said.
Plus, there is the added thrill of seeing an investment grow quickly, at least on paper.
鈥淧eople commit to a Ponzi Scheme because they want to be winners. Earning money steadily by hard work seems so pedestrian compared to the temptation to get rich quick,鈥� Ketz said. 鈥淎 lack of clarity about the workings of an investment plan should be an immediate red flag. Investors should be skeptical if fund managers say things like 鈥榶ou wouldn鈥檛 understand鈥� or 鈥榯hat鈥檚 private information.鈥� Those types of claims are attempts to deceive.鈥�
To avoid scams, he suggests, learn exactly how an investment plan works.
鈥淲arren Buffet is one of the world鈥檚 most successful investors, and he has often said that he does not invest in anything he does not fully understand. Those who follow his advice will not fall prey to a Ponzi Scheme.鈥�
Source: By Solmaz Barazesh, Research/Penn State
