Want easy money? See where you go

More often than not, schemes promising huge returns are Ponzi traps.

“Boy, I got vision, and the rest of the world wears bifocals.” — Paul Newman, as Butch Cassidy, in the all-time classic western Butch Cassidy and the Sundance Kid

I walked out of the airport and into the rain. She was there, waiting.

“Did you miss me?” she asked as I got closer.

“Must you know?” I replied.

“Ah, let it be. You know, I wanted to talk to you about an investment I wanted to make,” she said.

“What investment?”

“This friend of mine wants me to invest in an investment scheme that promises to double my money in six months. Isn’t that exciting? A 100% guaranteed return in a year.”

“But where will they invest your money to be able to give you that kind of return?”

“Oh, let them invest where they please. All I am bothered about is my 100% return.”
“I wish life were as simple, my dear. Let me tell you a story.”

“A story? Go ahead.”

“Double your money in 90 days! That’s what Charles Ponzi, an Italian immigrant to the US, promised investors way back in 1919. In August 1919, in the process of issuing an export magazine, Ponzi spotted a huge arbitrage opportunity. He made an offer to a person in Spain, requesting him to subscribe to an export magazine he planned to launch. The subscriber sent Ponzi an international postal reply coupon, which could be exchanged at the local post office, for American stamps, needed to dispatch the magazine to Spain. In Spain, the coupon cost the equivalent of one cent in American currency. But when he exchanged the coupon in America, Ponzi got six cents worth of stamps. Sensing the arbitrage opportunity, he decided to float an investment scheme.”

“But what’s this got to with my investment,” she interrupted.

“Have patience. Ponzi’s scheme promised to double investors’ money in 90 days. Money started pouring in. Once the money had been collected, Ponzi planned to convert American dollars into foreign currency, buy international postal reply coupons from various countries, convert them into American stamps and sell them for a huge profit. The idea was brilliant. But Ponzi had not taken into account the difficulties involved in dealing with various postal organisations around the world, along with other problems involved in transferring and converting currency. Nevertheless, the investors got attracted to the huge returns the scheme promised. At its peak, the scheme had 40,000 investors who had together invested around $15 million in it. Meanwhile, Ponzi had started living an extravagant life, blowing up the money investors brought in. On July 26, 1920, the Boston Post ran a story questioning the legitimacy of the scheme. Within a few hours, angry depositors lined up at Ponzi’s door, demanding their money back.
Ponzi asked his staff to settle their obligations. The anger subsided, but not for long. On August 10, 1920, the scheme collapsed. The auditors, the newspapers and the banks declared that Ponzi was definitely bankrupt. It was revealed that only two stamps had been actually purchased. Money brought in by the new investors was being used to pay off old investors. Since then, this form of financial fraud came to be generically known as a Ponzi scheme.”

“So?” she asked.

“Let us say I start a scheme promising to double money in six months. I can invest that money somewhere and hope it gives me enough returns in six months so I can redeem the amount I had promised the investors. But, generating 100% returns in six months is not easy and wasn’t the idea in the first place. Taken in by the huge returns I am offering, people who invest in the scheme initially will go out there and tell other investors about it, so more investors will start investing in it. Six months later, when I need to pay off the initial lot of investors, enough new money would have come into the scheme to allow me to pay off the initial investors. And so the scheme keeps running.”

“That’s a dangerous game to play.”

“So it is. It is important to note that in a Ponzi scheme no new wealth is created. Wealth gained by participants entering the scheme earlier is the wealth lost by those coming in later. Such a scheme can keep running only till the money entering the scheme is more than the money leaving the scheme. The moment the flow reverses, the scamster might vanish with whatever money he has left. Thus, the most vulnerable investors are those who come at the end.”

“Are you saying my friend wants me to invest in a Ponzi scheme?”

“Without doubt. There is no other way to generate 100% returns in six months. If you have been reading the newspapers, there has been a spate of exposures of Ponzi schemes of late. Ashok Jadeja, a scamster, was caught for defrauding investors of around Rs 1,600-2,000 crore. If news reports are to be believed, he claimed he could triple investments in 15 days. In another case, in Delhi, Ranbir Singh Kharab, a former MLA, and one Subash Aggarwal, siphoned off Rs 3,200 crore from around 10,000 investors. “

“But how do these fraudsters pull it off?”

“Well, the most important part of a Ponzi scheme is assuring investors that their investment is safe. Early investors become the most important part of the scheme and meeting initial obligations is very important. Ironically, in many cases, it is the investors’ own money that is being returned to them. Let us say someone invests Rs 100 in a scheme that promises a return of Rs 20 in 2 months. Now, even with no new money coming in, the scamster can keep returning the investor Rs 20 of his own money every two months, and keep the scheme running for ten months in the hope that the investor will go and tell others about the scheme and get them to invest in it.”

“I must be a fool to have considered investing in such a scheme. But how come such schemes keep surfacing time and again?”

“The attraction of easy wealth is hard to beat. Ponzi Schemes offer huge returns in a short period of time vis-a-vis other investment options available in the market at that point of time. With good advertising and stories of previous investors who made a killing by investing in the scheme, investors get caught in the euphoria that is generated and hand over their hard earned money to such schemes going against their common sense. Greed also results when investors see people they know make money through the Ponzi scheme. As economist Charles Kindleberger famously wrote, “There is nothing so disturbing to one’s well being and judgment as to see a friend get rich.”

The example is hypothetical