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After the Bernie Madoff scandal rocks the financial world during the economic recession, many people were left wondering, just what is a Ponzi scheme? How could such a thing defraud so many smart people, and cause so many people to lose so much money? How could things go so long without being detected?

There are many characteristics of Ponzi schemes, and so there are some things that you can try to watch out for to avoid them. For one, it will usually offer an abnormally high return in a short period of time. This looks great to new investors, and that's what its supposed to do. People can get sucked in by the potential of quick money, which is why they can be so popular.

How do they pay these abnormally high returns? After all, if they didn't pay anything out, it would quickly be found to be a scam, and the perpetrator would have no motivation to do it in the first place. So the first investors are usually paid off by the newest investors, or from current investors reinvested their money, not by profit that the company is making (which is the case for a successful business or investment technique). This makes it appear to be a legitimate way to make money, but when the investors stop, the payouts stop, and you're left there losing all of your money.

Ponzi schemes usually don't have any other way to make money other than the new investors. Again, this is why its so critical to get new investors, because without new investors there is no money coming in, and then the whole system collapses. The new investors pay off the returns for the old investors, which keeps things running smoothly as long as the new investors are coming in. If the new investor rate stops or slows down, it is revealed that the whole thing is built on sand, ready to collapse at any time.

The system was originally named after Charles Ponzi. So these are just the basics of a Ponzi Scheme. If you see something like this, don't let greed overcome you, because the chances are good that you will lose your money. Ideally these would be discovered to be fraudulent very quickly, but oftentimes the perpetrators can keep the scheme going for a long time, eventually hurting a lot of people once it eventually and inevitably collapses.

Learn more about this author, Juan Leer.
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