Thursday, July 16, 2009

Ponzi Scheme Evolution

A common misconception about Ponzi schemes is that the criminal running the scheme runs off with all the money owed to investors. In reality, by the time the Ponzi scheme collapses, there is no money.

Imagine the following simplified Ponzi scheme. Bob, the friendly financial guy, gets people to invest $500,000 (inflation adjusted) with him each year. Bob reports a return of 5% above inflation every year to his investors after his fees, and the investors withdraw 10% of their money every year.

However, in reality, the financial statements Bob sends out are lies because he is only making a return of 3% above inflation, and he has been taking $100,000 of investor money each year to spend on himself.

This means that the amount of money invested is actually less than the total Bob reports to his investors. Unfortunately for Bob, investors withdraw 10% of the larger fictitious amount each year. The following chart shows how the claimed assets and real assets grow over the years.

From the chart we see that Bob runs out of money in the 28th year. In the first few years, the shortfall was small, and Bob could convince himself that he could make up the difference if he had to. By the 10th year, it is becoming obvious that the gap is too large to make up, but real assets are still at a comfortable level.

After 20 years, it’s apparent that the scheme will eventually collapse. Bob is in way too deep now to save himself. Complete collapse happens rapidly in the last few years.

The important thing to note is that the claimed assets that investors see on their account statements are a fantasy. The money doesn’t exist. When Bob goes into hiding, only a tiny percentage of the money owed investors is available to return to them.

1 comment:

  1. Very enlightening. I can't imagine putting investors or myself through that kind of pain. Yes, the investors do get a raw deal, but it must also be stressful for the Ponzi operator as well, especially in the awful end game.

    Makes me think that Ponzi operators are either caught off guard by the collapse or are psychopaths.