How Ponzi Schemes Work

How to Smell a Ponzi Scheme


­Because they can take the form of any kind of investment, Ponzi schemes can be hard to spot. However, if you know what to look for and you're careful, you should be able to avoid them. Here are some helpful tips:

  • Fools rush in: Don't let anyone pressure you into an investment. If you feel you're being pressured, that's all the more reason to suspect that something's awry. Take your time in making your investment decisions.
  • Unrealistic returns: You've probably heard this piece of advice before, but it never hurts to repeat it -- if it sounds too good to be true, it probably is. For the victims of Allen Stanford's Ponzi scheme, that old adage certainly turned out to be correct. When you're approached with an opportunity that seems unbelievably amazing, you should be highly suspicious. Investigate it as much as you can before you fork over any funds.
  • Steady as she goes: As with the Madoff scam, the returns in a Ponzi scheme don't necessarily have to be unbelievable, so the previous tip won't always help. However, many say that Madoff's and victims should've been suspicious of how steady and consistent their returns were. They were always moderately good; real investments returns fluctuate.
  • Devil is in the details: If you do enter an investment, carefully examine what information the company provides. A suspicious lack of details should be a red flag  [source: Burrows].

Lou Pearlman, Allen Stanford and Bernie Madoff were able to elude exposure for so long because their schemes were particularly sophisticated. So how can you protect yourself from the super smart shysters? The best protection is diversification. Overall, it shouldn't be the end of the world if you do happen to be the victim of a Ponzi scheme. Financial advisers always suggest you diversify your portfolio. Invest in multiple places and in different industries. No one investment should account for more than a quarter of your whole portfolio [source: Burrows]. That way, if you find yourself in the bottom rung of a Ponzi scheme, you can get out without losing your entire savings account

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