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Ponzi schemes: What they are and how to avoid them

Laura Carson Miller is freelance lifestyle writer in Atlanta, writing for magazines and the web. Her favorite subjects include beauty, health/wellness, and financial issues. She is also an avid cook, gardener, fashionista and interior st...

red flags for ponzi schemes

Today I'm looking inside Ponzi schemes and how they operate, in hopes that this knowledge will keep you from ever getting involved in such a thing.
Bernie Maddoff

What it is

Named after Italian businessman Charles Ponzi, who got the best of many an investor in the early 1920s, the Ponzi scheme lures investors with promises of extremely high yields, little risk and sometimes a quick turnaround, too. The problem is that there is actually little to truly invest in and the puppet money master is merely a gerbil on a wheel being spun by investors' money.

Usually run by a charismatic personality, who claims to have insider information or vast experience in specific types of investments, people looking for a safe way to grow their nest egg can find this presentation highly appealing. At the appointed time, investors have their investment returned with the promised interest or sometimes, with a higher rate than originally agreed upon. With both the investor and the money manager sitting pretty, the investor is likely to invest again, and with more monetary gusto, and tell family friends about their financial success. This creates a bigger pool for the investment manager, who is often using the money to live a pricey lifestyle.

As long as more and more people continue to contribute to the investment, the manager is able to use funds from others to pay back initial investors and keep everyone happy. It's when the well of new investors runs dry that the problems begin and the unraveling of the scheme becomes evident.

What to look for

The obvious set of questions comes to mind: Is the person licensed and experienced; does the person have good credentials; do they have a long list of satisfied customers you can speak with? Even if you get a chorus of positive responses, you can still be dealing with someone who can take you for a ride. You should think twice if the person asks you to make checks payable to them or their company or they show you paperwork with numbers that look too good to be true, because they likely are!

Unfortunately American Greed has episode after episode where investors were shown lengthy paper trails of successes that were handily invented on the computers of the fraud master. Take the time to thoroughly research your investment manager and make sure they have not been arrested or investigated surrounding their business dealings. You can do a check through Financial Industry Regulatory Authority (FINRA) to help give you more information. If anyone is offering you a guaranteed return or says your investment is basically risk free, run for the hills.

Famous financial felon

One of the most notable purveyors of a Ponzi scheme, who ended up behind bars and on our television screens, is Bernie Madoff, whose Ponzi scheme is considered to be the largest financial fraud in U.S. history. Bernie made off (sorry, I could not help myself) with an estimated $50 billion over time, yet he had all the fancy credentials any would-be investor longed to see, including serving as the non-executive chairman of the NASDAQ.

As the old adage goes, if an investment seems too good to be true, it is. Whenever anyone offers you "a sure thing," you have every right to be skeptical and put the brakes on both literally and figuratively. And especially if a money manager is encouraging you to give them all your available assets, you will know that is not the right person or investment for you. You should never put all your eggs in one basket, no matter how attractive the manager might make the basket look.

More on finances

How to plan a home budget
How to lower your tax payments
5 Tax deductions you didn't know about

Photo credit: United States Department of Justice
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