It's a question that gets asked the moment word of a Ponzi scheme breaks headlines:
"Uh, what is a Ponzi scheme?"
And it's a very good question…
One with a complex answer.
Here's the gist: A Ponzi scheme happens when a schemer runs a fraudulent investment management service. He acts as a "portfolio manager," promising high returns. All the schemer has to do is nab a few investors into getting in on what he likely advertises as a "once-in-a-lifetime" business venture. The details of the investment don't matter too much; what suckers people in is the promise of fantastic and fast returns.
After the schemer has convinced first-round investors to fork over money, the funds can bankroll something fancy – a new house or sports car. If the conniver is truly sneaky, he'll use the money to set up a business front that will help con his next round of investors.
And initial investors in the fake service do receive payouts as the Ponzi scheme runs its course — but not from the "quality" of the portfolio or the money manager's prowess.
Instead, they are paid with incoming funds contributed by new investors…
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You see, in the second round of the scheme, the conniver needs to find more people interested in his fantastical venture. He'll use the money garnered from this new batch to pay the promised returns to the first-round investors – but only after skimming a bit off the top for himself.
Eventually, this second round of investors will also need a payout. So the "promise and recruit" process is repeated. The money from a fresh third round of investors will then be used to pay off the second round, and so on and so forth. All the while, the schemer is skimming funds for himself.
As the cycle goes on, it gets more complicated and difficult to maintain. Earlier rounds of investors will get suspicious if they don't continue to see returns. New investors will have to be paid back their initial investments, and the schemer will have to appease them with regular returns. This means that new investors will have to be continuously added to the Ponzi scheme in order to pay all the previous rounds.
Eventually, the Ponzi scheme collapses. They're ultimately doomed as there is never enough money to go around. And the schemer knows this. As the plan unravels, the schemer will attempt to exit the business altogether and run for the hills.
Source: Money Morning
