In Boston in the 1920s, there lived a highly successful businessman named Charles Ponzi. He ran an investment company which promised clients that any investment they made with him would be doubled in just three months.
Ponzi was trading in something called international reply coupons, which could be used to buy postage stamps in different countries. He bought these coupons for a cheap price in his native Italy and exchanged them for more expensive stamps in the U.S., hence earning a profit. Ponzi made his promises of doubling his clients’ investments hoping to keep taking advantage of the difference in stamp prices. (In fact, taking advantage of different prices for the same item in different markets is still a popular investment strategy. It’s called ‘arbitrage’.)
What's the strategy? Obviously, when Ponzi started advertising his fantastic returns on investments, crowds rushed to his office to entrust him with their life savings. In just months, his investment scheme grew by leaps and bounds.
But soon, some people grew suspicious of Ponzi’s strategies. They wondered how an impoverished ex-convict like Ponzi managed to build such a successful business in just a few months’ time. Ponzi’s sudden wealth attracted a lot of attentions from financial investigators. They found that Ponzi was using the money invested by new clients to pay back old clients. That is, if A invested $100 with Ponzi’s company in January, he paid A back $200 in April using the $100 that B and C had each invested with him sometime during the three-month period. Investigators also found that there was no way Ponzi could actually buy the number of international reply coupons he needed to earn profits from his clients’ investments simply because there weren’t that many coupons in existence. Besides, the costs involved in transporting any coupons he did buy from Italy and selling them in the U.S. were so high that he was making losses, and not profits.
Short-lived success Ponzi’s success was short-lived. By August that year, his investment scheme unravelled and Ponzi became bankrupt. His investors, many of whom had taken loans against their homes to invest in his company, lost $20 million in total.
However temporary Ponzi’s success turned out to be, his legacy in financial history lives to this day. Even now, any investment idea that operates like he did in Boston in 1920 is called a ‘Ponzi scheme’.
Over the years, experts have found similarities in Ponzi schemes around the world. First, they all offer ridiculously high interest rates (or returns on investment) in order to attract as much money as they can from easily duped people. Second, there is never any real investment strategy involved. In almost every case, the creators of such schemes use recent investors’ money to pay off old investors. Third, all Ponzi schemes, regardless of how elaborate they are, ultimately collapse.
India's stories Ponzi schemes are born all over the world. India has had its fair share of them. For six years, people in rural Tamil Nadu invested their money in contract farming of emu birds based on promises of extravagant returns made by a certain agency in Erode. In 2012, that scheme collapsed and several farmers were stuck with emu birds that no one wanted. .
The government is trying to make regulations stricter so investors won’t be duped so easily. However, when someone promises to work magic with your money, you should remember that magic isn’t real.
If there is anything else you want to know on the subject, write in to tanya.et@thehindu.co.in.
