The History of Ponzi Schemes
When Enough Isn't Enough
Most people first heard of a Ponzi scheme in 2008 when Bernie Madoff made it famous. And although he may be the most famous schemer, he is not the creator of the Ponzi scheme. That designation goes to the man Ponzi schemes are named after, Charles Ponzi.
A Ponzi scheme is defined as a form of fraud where investors are promised large returns on their investments through legitimate means. However, their money is never invested in anything legitimate. Instead, early investors receive a return on their investment through the investments of late investors.
A Ponzi scheme will look legitimate as long as the following remains in place:
New investors continue to add money
Earlier investors continue to receive a return on their money
Investors do not demand a full return on their investments
There’s a powerful quote I often think about from the book How Will You Measure Your Life? by Clayton Christensen:
The first step down that path is taken with a small decision. You justify all the small decisions that lead up to the big one and then you get to the big one and it doesn’t seem so enormous anymore. You don’t realize the road you are on until you look up and see you’ve arrived at a destination you would have once considered unthinkable.
How it Started
Charles Ponzi came from humble means. He was born in Parma, Italy, and came to America in 1903 at the age of twenty-one. Ponzi’s life in America began by working various jobs from a busboy, to an office clerk, and vegetable wholesaler.
Like many Ponzi schemes, Charles’s scheme started as a legitimate means to invest money. In 1919, while living in Boston, Charles discovered a way to make extra money by trading international postal coupons. These coupons allowed anyone to send or receive letters or packages from abroad. Ponzi realized he can purchase coupons outside America at low values and then sell them in America for a profit. This allowed Charles to make $3.50 for every $1.00 invested, and it was legal.
Charles Ponzi opened his investment to others by promising them a 50% return on their investment every three months. Very few investors would turn that down today, let alone in 1919. Charles began to be overwhelmed with the money that was pouring in as more people heard about his investment returns. He could have closed his investment and managed the money he had, making himself and his investors very rich, without committing fraud. Instead, he continued to accept new investors and soon had thousands of people lined up outside his Boston office with money to invest. Charles had so much money coming in that he could not put it in the bank fast enough. At one point he had $2.5 million stuffed all over his office, in shoe boxes and desk drawers.
Ponzi was beyond the point of enough, he was now in over his head and could not keep up with the investment side of his business. He decided not to invest the money that continued to flow in, even if he wanted to it would prove to be difficult. Instead, he began to provide a “return on investment” to earlier investors using the deposits of new investors. Around the same time, he began to open new offices all over New England to take in even more money.
Like most things in life, it’s what you don’t expect that can cause you the greatest harm or benefit.
The Ponzi scheme Charles created began its downfall when a newspaperman happened to ask a postal worker how they were coping with the demand brought on by Charles Ponzi. To the newspaperman’s astonishment, the postal worker commented that there was hardly any demand coming from Charles. And so the scheme began to unravel.
A scheme that lasted 8 months, took in $10 million and attracted almost forty thousand investors, unraveled with a curious question from a newspaperman.
Charles Ponzi was charged, convicted, and sent to prison for three and a half years. And will forever live in infamy as the creator of the Ponzi scheme.
How it’s Going
Bernie Madoff followed a similar path as Charles Ponzi. Before Madoff’s scheme was unraveled, he was a wealthy and legitimate investor. At one time, he was the Chairman of the NASDAQ stock exchange.
In 1960, Bernie founded Bernard L. Madoff Investment Securities, which was a highly profitable securities firm. His firm had a legitimate business that would execute trades electronically at a faster speed than other brokers. Madoff made his money by keeping the difference between the highest price a stock buyer will offer (the bid), and the lowest price a stock seller will accept (the ask). It was estimated that his business made between $25 million and $50 million per year.
Bernie Madoff founded a legitimate, non-fraudulent business that made him wealthy well beyond his wildest dreams. And yet, he wanted more. As he became friends with other wealthy and influential individuals, he began to compare his wealth to theirs. By comparison, their wealth made his seem small, and may have been the reason he felt the need for more.
Madoff began his Ponzi scheme around the 1980s by investing the funds of his wealthy friends and giving them an annualized return of 10%, regardless of what the overall market was doing. As more people learned about Madoff’s returns and his prestigious client list, he began to benefit from a higher inflow of funds and fewer questions.
Like Charles Ponzi, Madoff did not invest the money he was receiving. Instead, he was depositing the money into a bank account that he was managing. The “returns” he was providing his earlier clients were coming from the new money being “invested” by later clients. He was able to conduct his Ponzi scheme for decades until an unexpected event unraveled the fraud.
The market meltdown of 2008 caused many investors to lose everything. Those who were invested with Bernie Madoff thought they may have weathered the storm due to the fraudulent statements they were receiving from Bernie. For Madoff’s clients to cover losses in other investments, they decided to withdraw their money, all at once, from their investment with Madoff. As we learned earlier, a Ponzi scheme is only able to survive by new money flowing in and when investors do not demand a full return on their investments. Both criteria were absent in 2008 when Madoff confessed to his two sons that his investment was “one big lie”.
Beginning in the 1980s, Bernie Madoff stole more than $64 billion from thousands of investors over several decades. However, he took more than money from those investors. He stole their reputation, dignity, and led a few victims of his fraud to commit suicide.
In 2009, at the age of 71, Bernie Madoff pleaded guilty to 11 federal felony counts and was sentenced to 150 years in prison. He was also ordered to forfeit $170 billion in assets. Bernie Madoff was later quoted as saying:
I had more than enough money to support my lifestyle and my family's lifestyle. I didn't need to do this for that. I don't know why.
By any metric, Madoff had enough. He allowed his need for more, and the influence of social comparison to convince him that enough wasn’t enough. And as he pursued more, and one fraudulent activity led to another, he became the author of the largest Ponzi scheme in history.
Bernie Madoff died at the age of 82 while serving a life sentence in federal prison.
When Enough isn’t Enough
The stories of Charles Ponzi and Bernie Madoff could have been different. Both men could have been successful beyond any measure of success and lived a comfortable life. All they had to do was stop reaching for more and realize they had enough. Had they done so, they would have been remembered as great investors rather than felons who combined to steal billions of dollars from thousands of investors.
Not knowing when you have enough will not always lead to a felony. As we will learn from two entrepreneurs who created similar companies yet took different paths. One walked away when he had enough, and the other didn’t.
Tom Anderson co-founded the social networking website Myspace in 2003. Many of us remember him as our “first friend” on Myspace as he sat in front of a whiteboard filled with writing. In 2005, two years after its launch, Tom sold Myspace to News Corp for $580 million. Then, Tom disappeared. He spent his time doing what he pleased, including being a photographer and traveling to exotic places worldwide. Tom won the game by walking away when he had enough. He made the goal post stop moving.
Mark Zukerberg also co-founded a social networking website called Facebook. In 2006, one year after Tom sold Myspace for $580 million, Yahoo offered to purchase Facebook for $1 billion. Mark turned them down, and many other offers for similar amounts. Today, Mark is still the head of Facebook and is living a much different life than Tom from Myspace. Mark must answer to angry shareholders when the stock price is in a slump, is amid lawsuits for data tracking and other accusations, and is often being dragged in front of Congress for questions about the ills of social media. All this happened during the 15 years after Yahoo offered him $1 billion to walk away from the company and live life on his terms.
Before you think this is a problem only the ultra-wealthy suffer from, think about your life and areas where you strive for more after the point of enough has come and gone. We can look at three of the most common areas:
Career:
Many of us will reach a point in our careers where we have enough. We will have the right amount of responsibility to give us a balance between work and life. Your current job will give you enough fulfillment and a sense of purpose. Then, you will reach for one more promotion, look for a different job outside your current company, or find a side hustle that will fill what is missing in your day job. And before you realize it, you are reaching again, then maybe one more time, until you reach a point where you are burned out and your life is out of balance.
You had enough, now you have too much, and you’d do anything to go back to where you once were.
Money:
After a certain point, more money will not make a material difference in your life. You will reach a point where all your needs and your most important wants are satisfied by the amount of money you have. Then, you will reach for a little more money because you see those around you with bigger homes, fancier cars, or better vacations. You become a victim of social comparison. And as Morgan Housel states in The Psychology of Money:
There is no reason to risk what you have and need for what you don’t have and don’t need.
Money, in and of itself, does not have any intrinsic value. The value of money comes from the value we place in it, and the value we place in money comes from the lifestyle we adopt. As our lifestyle needs increase, so will the need for more money and the value we place on money. The easiest way to eliminate the need for more money is to live below your means regardless of how fast your income rises. In other words, avoid lifestyle creep.
Relationships:
Those who are blessed to be in a healthy relationship may take their relationship for granted. You may think that a different partner will fill the needs that your current partner isn’t. In most cases, you will trade 90% of what you need for the 10% that you want. In any situation, that’s a bad tradeoff. The idea that someone else will fulfill all your desires in ways your current partner doesn’t will lead you to make decisions that will jeopardize everything you have. Before you know it, you will be searching for something that doesn’t exist.
Many people will risk what they have for the illusion of what they are missing, only to realize that everything they had was everything they need.
Conclusion
The simplest way to avoid the need for more is to eliminate the addiction to comparison. In life, there will always be someone who has more than you. The faster you can accept that life isn’t a race for more, the faster you will be content with what you have. As the poet Russ once said:
I try to run my race and not care about who's ahead of me. Because comparison is the recipe for depression and questioning your integrity.
For most of us, the pursuit of more will not lead to committing a felony, I hope. However, the pursuit of more money, attention, or status, will lead to a prison of never being content. And although the prison of more may not land you behind bars, it will trap you on the hedonic treadmill. Which is similar to being in prison, just minus the bars.
