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Word of the Day: Ponzi Scheme

Overview

A Ponzi scheme usually offers abnormally high short-term returns in order to entice new investors. The high returns that a Ponzi scheme advertises (and pays) require an ever-increasing flow of money from investors in order to keep the scheme going.

The system is doomed to collapse because there are little or no underlying earnings from the money received by the promoter. However, the scheme is often interrupted by legal authorities before it collapses, because a Ponzi scheme is suspected and/or because the promoter is selling unregistered securities. (As more and more investors become involved, the likelihood of the scheme coming to the attention of authorities will continue to increase.)

The scheme is named after Charles Ponzi, who became notorious for using the technique after immigrating to the United States from Italy in 1903. Ponzi was not the first to invent such a scheme, but his operation took in such a large amount of money that it was the first to become known nationwide. Today's schemes are often considerably more sophisticated than Ponzi's, although the underlying formula is quite similar and the principle behind every Ponzi scheme is to exploit lapses in judgment arising out of greed.

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