With all of the talk about Bernie Madoff heading off to jail for a few years (a century or so) the thought on a lot of people’s minds is How did he do it? and What is a Ponzi scheme?
I came across the post Explaining the Ponzi Scheme to a Fifth Grader via Stumble Upon recently. I think the explanation pretty much nails it! Here it is:
Say you went to your sister and told her, if she gives you a dollar to invest today, you will give it back to her on Tuesday next week and she will get $1.25. Then you go to your other sister and tell her the same thing only you will give her $1.25 Wednesday. Then you go on to your dad and every person you know and tell them the same thing. As you’re going around asking for money from other people you know, you give your first sister her $1.25 and she’s happy to have twenty five cents extra just for letting you invest her $1. So she says, why don’t you keep my dollar and invest it some more? So you say, OK.
But the thing is, you weren’t really investing it were you? You were just using other people’s money to make it look like you are earning money for them. Do you see how you will eventually run out of money especially if they all ask for their money at the same time?
So she answers, Yeah, but can’t I just ask more money from more people? Yeah, you can do that but what if you ran out of people to ask and also ran out of time? That’s what happened to Bernie Maddox and that’s why he’s going to jail.
She then said, but they said he still has millions of dollars and he’s not really in jail. True.
About $68 billion lost summed up pretty nice!
The are a couple of lessons in this:
Know what you are investing in AND There’s no such thing as a free lunch!
You have to know where your money is going. If not then you are asking for trouble. From what I’ve been hearing people were throwing their money at Madoff so he could invest it. They didn’t care how he did it so long as they got back huge returns. I feel horrible for those people who lost their retirements and for all of the charitable organizations that were hurt. But you have to ask the big questions and in this case the questions is Where is the money going to get those returns?!?
It may not be fun learning about personal finance and investing but a little knowledge goes a long way. Sure it’s fun to say you’re getting 15% every year on your investment but you have to questions how!
Am I being too harsh?
I don’t mean to be. These people were swindled and hurt! The whole situation bothers me. It seems there’s no real accountability with Wall Street any more. There were warnings going back a decade about Madoff’s “investments” that went ignored.
Here’s a little lighter side that I also picked up from AMoores (where I saw the simple Ponzi explanation):
How do you feel about it all?
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The hard part about Ponzi schemes is that they are so awesome for the people who are in early. So the marketing is good until people realize and the scheme crumbles.
I had a family member that got involved with the pigeon king ponzi that created an artificial market for a real product(pigeons). He was in long enough to a good chunk of his money back, but not all of it. He was out investments, time, and energy before the scheme fell.
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@ Happy Rock – I can see how easy it would be to get sucked in. With Madoff he was also seen as a success in Wall Street besides his fund. They saw the emperor but didn’t want to see he had no clothes. Sorry to hear about your family member!
You wonder how things like this can get so big and go on so long… and how Madoff must have felt throughout it. I mean, he looks kind of relaxed. I think I’d be going through all kinds of hells.
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@ Bill – Who knows how he feels? We know that he tried to mail out stuff so he was trying to get some people money real quick before he was jailed. But we can’t tell if he’s truly sorry for what he did. I wonder how much fallout there will be in this and if anyone else will be implicated?
This is a great explanation.
I think what he did was very despicable and sad. My hope is that the families and people affected by this will be able to recover.
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Thanks for this great explanation. It is especially important to understand what you are doing — and to be wary of returns that always hit the mark, year after year.
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It’s funny that this post came up this week for me because I’ve been watching old episodes of the show OZ (trying to cut down on entertainment costs by watching DVDs already around the house) and they mention Ponzi schemes a lot. I didn’t know what they were and had looked them up but didn’t quite get the definition. Your simplified explanation here really makes sense. Thanks!
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Thanks for posting that explanation. Watching the various families who were victims of this scheme on Suze Orman, FBN, etc. really brings home the fact that real peoples’ lives were being destroyed by one person’s greed and stupidity.
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Great explanation! I had thought about writing a similar post, but I really like yours. Nice job!
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Thanks for the linkback
This morning I heard that people who lost money through ponzi schemes can claim a loss on their income tax as ‘theft’. Previous ‘capital gains’ claimed can also be credited.
This will help a little, but I think for most people it’s not going to make a difference, sadly.
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