You know the old adage: “If it seems too good to be true, it probably isn’t?”

The gentleman that said it first was the victim of a Ponzi scheme.

For sure.

So – the Ponzi scheme. It’s a word that most people associate with those product fliers that you occasionally find attached to your windscreen – with glossy photographs of well-manicured housewives and large-fonted promises of earning “up to R50,000 a month – it’s in your hands!!” On the back, there are many testimonials of how the product/retirement vehicle/stream of income changed lives and influenced people. And there’s always a guy that abandoned “a successful career in orthodontic dentistry” to pursue his lifelong dream of owning a Jamaican small-holding with an infinity pool and a personal chef.

It confirms that Einstein theory that the only thing that he can be sure of is that human stupidity is infinite. Stupidity? It’s a strong word. But we’re emotional and easily gullible when we want to believe that it’s easy. And we do.

Ponzi schemes are named after Charles Ponzi, who was the famous con artist of the 1920s. And typically, like most financial crises, he started with a really good idea.

In the 1920s, post was king. And that meant that stamps were the crown jewels. At the time, there was a coupon available (the “International Reply Coupon”, or IRC) that you could attach to the letter that you were sending, and the recipient would then be able to go into a post office wherever he was (provided that he was in a country that belonged to the Universal Postal Union – and almost all countries were/are) and exchange it for a stamp that equalled the price of sending the letter back. That, or redeem the cash (so I’ve read). And this was quite useful, because most countries in the 1920s had much stricter capital controls than today: and the IRC allowed you to circumvent the purchase/sale of foreign currency and the purchase of foreign stamps.

But the exciting part (from Mr Ponzi’s perspective) was that he realised that these IRCs could be redeemed anywhere, but had different prices in different countries. For example, high inflation in the mediterranean countries made return postage much cheaper in US dollar terms than return postage from the States. This created an arbitrage opportunity. So, as an example, I’m going to use a hypothetical scenario involving the USA and Mexico. Let’s say that an IRC is worth $1.50 in the USA, and costs an effective $1.00 in Mexico. And let’s say that I live in Texas, within close proximity of the Mexican border. I could do the following:

  1. Borrow $1,000 from my bank.
  2. Jump the border.
  3. Buy 1,000 IRCs with it.
  4. Jump the border again.
  5. Redeem the IRCs for $1,500 at a US Post Office.
  6. Pay the bank back $1,000.
  7. Keep the $500 profit.

And that, in a nutshell, is arbitrage. “Risk-less” profit – although there were a few risks in the above example, if I’m honest. But anyway – that’s the general idea.

So Charlie spotted this, and said to himself, let me get other people to join in. So other people got involved in this fabulous opportunity to make risk-less cash. At some point, I’m sure people must have asked some of the following questions:

  • What if you can’t redeem all the stamps?
  • Surely it costs money to move from one country to another – how are you covering that cost?
  • Ummm – how is it that the total value of your investment exceeds the value of the world’s supply of IRCs? (my personal favourite – this question was asked when people realised that his total amount invested implied that there were around 160 million IRCs in issue. In reality, there were about 27,000).

As it happens – not a lot of arbitraging taking place. What was going on was something like the following (they weren’t calling it a Ponzi scheme yet – so I guess they went with the more traditional “pyramid scheme”?):

  1. Charles tells his closest buddies about the opportunity. He says he can get them a 50% return in 45 days (genuinely what he claimed). They give him $100 to start with.
  2. He pays them $50, and is left with $50. They think he still has the $100. They tell him to keep it so that he can do it again. They also tell their closest buddies about it. The second group of investors give Charles $200.
  3. 45 days later, Charles pays everyone back $150 (50% of $300). The investors think that he still has the original capital of $300 (in reality, he has $300 – $50 – $150 = $100). The second group of investors tell their closest buddies about it. The third group of investors give Charles $400. Note: as the investors tell people, there is exponential growth occurring. 1 person tells 2 people (now 3 know). Those 2 people each tell 2 more people (now 5 people know), and so on.
  4. Charles pays everyone back $350 (50% of $700). The investors think that he still has the original capital of $700 (in reality, he has $700 – $50 – $150 – $350 = $150).
  5. And so on – you have an expanding investor base, with new capital being used to pay these artificial returns.
  6. These investor bases cannot grow indefinitely. Eventually, the scheme grows too big, and not enough new investors can be found to finance the expanding return requirement.
  7. But let’s just assume that there are no new investors after the third group. In the next round of payments, Charles will need to pay out another $350. He can’t, because he now only has $150 left.
  8. So, he announces a loss.
  9. As investors start to withdraw their money, they realise that there is no capital left. Charlie has been robbing Peter to pay Paul, as the saying goes.

And that, more or less, is a Ponzi scheme. Someone comes out with a crazy investment idea that seems to make sense. People invest. They get the returns promised. More investors flock to the “opportunity”, generating more returns. And so on, until the con artist disappears with the cash, or some external factor makes the investors attempt to withdraw their money.

The latter situation is what happened with the Madoff Ponzi scheme. When the Subprime Crisis began, investors were trying to pull their investments out, and then everyone had the crushing realisation that the cash was gone.

So the next time you receive a flyer, chuck it.

And if your mate comes to you with this great investment idea – remember that high returns can very easily be a myth. However it’s captioned in financial jargon.