A Ponzi scheme is quite simple. The administrator promises to pay investors, or, more accurately, participants, a return that is above what is considered "natural". In reality there are no such investments but rather the returns are being paid out of the money coming in from new participants. This is the so-called "robbing Peter to pay Paul" routine. The name Ponzi comes from the infamous Mr Ponzi, an Italian immigrant to the USA who in 1920 ran the biggest Ponzi scheme at the time, taking an estimated $15 million. Ponzi promised to pay interest of 50% in 45 days or 100% after 90 days.

The biggest internet Ponzi scheme was 12dailypro, which offered 12% return per day for 12 days, equivalent to a 44% profit. When it was closed down by the Feds it had allegedly taken some $50 million. The authorities like to inflate such figures so this is more likely the turnover, and the Feds like to retain any money they seize rather than pay back some of the investors, which is a kind of scam in its own right.

But 12dailypro was nothing compared to Bernard Madoff's $50 billion Ponzi masquerading as a legitimate investment fund. Where 12dailypro was in the "get rich quick" mould, Madoff was into the long con. He offered above average long-term returns to investors largely within the industry - people who one believes should know better but obviously don't. However, it is possible to make money in Ponzis and it is possible to construct them so they last a long time.

The simplest of mathematical analyses shows that if a scheme merely pays people from its pot of money without investing anything then there comes a point when it runs out of money. In 12dailypro's case this happens after about 27 days without compounding, but after only 23 days if investors compound. As more new money pours in the bankruptcy date is pushed forward but never disappears. But Madoff realised that the sustainability of a Ponzi was not so much the rate of returns but also the rate of withdrawals. That's why he targeted foundations and charities, because under their rules they need to spend just 5% of their wealth. He therefore knew it would be unlikely there would be a run on his fund, and he theoretically had up to 20 years to keep the Ponzi going.

The analysis of how long a Ponzi scheme can last includes the rate of money coming in, the rate of return and the rate of withdrawal. Internet Ponzi schemes have largely been closed down after the Fed went not only for the schemes themselves but for the payment processors that allowed anonymous payments to be made and cashed out. There were such schemes that lasted 2 or 3 years but long-term online Ponzis suffer from the astute investors having too much knowledge! As Ponzis are a game they can be analyzed as a game.

Although deposits and withdrawals are normally kept secret - or if indicated on a website, not to be trusted - we do know the rate of return and we can use traffic data as a proxy for investments. Alexa is the most well known traffic data source but there are others. The basic rule of thumb is that the rate of growth of a Ponzi must be at least equal to the rate of return. As soon as the data starts to indicate the opposite, it is time to bail out.

However, having informed investors and greedy admins changes the nature of the game from a pure Ponzi to a Game of Chicken. With knowledge and distrust on both sides Ponzis get shorter and shorter in lifespan. It then becomes a flip of a coin as to whether one can make money or not. For Ponzis to become investment bubbles requires fresh new ignorant investors. Yes, Ponzis are always zero-sum games but some investors can make money from them.

As we enter a recession, and possibly a depression, it somewhat surprises me we have not seen a resurgence of online Ponzi schemes like back in 2003-2006. If it happens then remember this article. Ponzis are not investments, they are games, or scams, and like any game one can make money or lose it. However great the returns at some point it will fail. Above is a simple tool to avoid being the last sucker through the door.

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