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Why We Fall For Ponzi Schemes (And Other Scams)

A Ponzi scheme is a fraudulent endeavor that pays earlier investors with the money taken from later investors; there is no actual business investment. This scheme is also known as robbing Peter to pay Paul and it was around long before its namesake, Carlo Ponzi, introduced his version to the people of Boston in 1920.

Bernie Madoff was a more recent practitioner of a vast Ponzi scheme. His was one of the largest acts of financial fraud in U. S. history. Madoff was arrested for criminal securities fraud in December 2008.

Unfortunately, we can learn a great deal about decision-making biases from criminals and conmen. They have a knack for leveraging our cognitive blindspots in order to line their pockets. Let’s look at the Ponzi scheme from two perspectives. First, this fraudulent activity is the best example of doubling down or throwing good money after bad, one of the seven deadly sins of decision-making. The only way to sustain the con is to keep conning other unsuspecting victims. The con never ends. Doubling down on the original mistake (or criminal act) doesn’t stop until the crook flees or gets caught.

While most of us are not involved in Ponzi schemes, we are all guilty of doubling down on poor decisions from time to time.

It seems as if both of these men had the intention of running legitimate businesses, at least in the beginning. Ponzi discovered an opportunity to buy international stamp coupons at discounted rates with the “cheap” post-WWI currencies of certain European countries and sell them in the United States for much more valuable U.S. dollars. He even tested the theory by having a friend buy some coupons in Italy and ship them to Boston. By the time Ponzi figured out there wasn’t a market to sell the coupons in the United States, money was rolling in from investors. He was trapped and soon robbing Peter to pay Paul.

Madoff set up the Bernard L. Madoff Investment Secrurities LLC in 1960 with a loan from his father-in-law. By the accounts I’ve read, it appeared to be a legitimate business in the beginning. In fact, his firm helped to launch the Nasdaq stock market. It is not known exactly when his enterprise turned into a Ponzi scheme, but prosecutors believe he ran his business as a Ponzi scheme for decades.

The second perspective is how these criminals convince victims to invest in their schemes. Ponzi took in over $20 million in 1920, which is over $220 million in current dollar value. The average annual household income was around $2,000 at the time. It was quite a jump from grocery clerk to financial mogul in a little over a year. Why weren’t people suspicious? Prosecutors estimated $170 billion passed through Madoff’s account during his scheme. Before his arrest the firm's statements accounted for a total of $65 billion. I would venture to say Madoff himself might not even know the full extent of his fraudulent behavior. Needless to say, countless victims lost their nest eggs because they trusted these two con artists.

Just how did these crooks influence people to invest? During their schemes, both Ponzi and Madoff had their doubters. People suspected both of these men of foul play and yet the money kept rolling in. And, they didn't focus on the unsophisticated investor, many of their victims were smart, sophisticated, well-educated, wealthy people. These two crooks successfully bilked people by establishing credibility, demonstrating consistency and ultimately allaying risk aversion.


Charles Ponzi had no credibility. Prior to beginning his scheme, Ponzi was a 38 year-old Italian immigrant who worked in his father-in-law’s grocery store. His professional career was rather spotty. He had been a sign painter, a clerk, a bank manager and a translator, to name a few of his jobs. He had wandered all over the United States and Canada and did two different stints in prison before settling in Boston. Spending time in prison wasn’t something he like to share with his new friends.

When Ponzi came up with his coupon exchange investment idea, he formed the Securities Exchange Company and set up shop. Understandably, no one was buying in. So, Ponzi convinced a respected local Italian grocer named Ettore Giberti to sell the investment, called Ponzi notes, for a 10% commission. Giberti bought $10 of Ponzi notes in order to say he was an actual investor. Recruiting Giberti gave Ponzi’s scheme instant credibility.

Like Ponzi, Bernie Madoff had no credibility in the financial industry when he launched his company. He used $5,000 that he had earned from installing sprinkler systems and lifeguarding, as well as a $50,000 loan from his father-in-law, to found the Bernard L. Madoff Investment Secrurities LLC. His father-in-law happened to be a retired CPA who convinced some of his former clients and contacts to invest in Madoff’s new company. Like Ponzi, Madoff leveraged someone else’s credibility to get the snowball rolling.

These men used the principle of association, in-group bias and the power of social proof to quickly build credibility and influence victims to invest in their unproven companies.

Both Ponzi and Madoff leveraged their association with trustworthy people, a successful small business owner and a CPA, to build their credibility. These were respected men with large networks of potential clients. When they gave a recommendation to invest with Ponzi or Madoff, their integrity was passed onto the conmen.

They also began by selling to members of their ethnic group. Ponzi focused on Italian immigrants and Madoff targeted members of the Jewish community. We tend to trust people who are like us more than people who are not. Once they established credibility in their communities, they branched out to other targets.

Madoff would later build his credibility by becoming a board member of the National Association of Securities Dealers and served as Nasdaq’s chairman in 1990, 1991 and 1993. He was seemingly a pillar of society.

Finally, government officials, politicians, newspaper employees and policemen invested in Ponzi’s scheme and wealthy philanthropists and celebrities invested with Madoff. What other social proof would a potential investor need? These endeavors had to be legitimate, right?


Ponzi offered a 50% return on investment every 45 days. So, he was quickly able to show investors that he could and would pay them interest owed on their initial investment. It only took three months to establish a sense of consistency by paying initial investors for two different investment cycles (with new investor money, of course). Word-of-mouth was all the promotion Ponzi needed to grow his business. People were literally lining up in the street to give him their hard earned savings. Many investors let their initial investment “ride” in order to compound their profits, which helped the crook sustain the con. Delaying payment meant Ponzi could rake in more money without paying earlier investors. He used the difference to fuel his lavish lifestyle.

Madoff took a different approach. He became famous for delivering consistent and reliable returns around the 10% mark. When the market took a dive, Bernie was still able to deliver the goods… or so it seemed. While Madoff’s returns seemed modest compared to Ponzi, his consistent performance seemed to take all the risk out of investing.

Consistency leverages the cognitive psychological biases known as confirmatory bias and belief perseverance. We interpret information in a way that confirms our beliefs and once we have a belief, we seek to discredit evidence that contradicts our belief. Consistent results “prove” that our position is the right one. Investing with Bernie appeared to be a smart move.

Risk Aversion

I have read that the primary driver leading victims to invest in these two schemes was greed. That may have been a factor, but I don’t necessarily think it is fair to call these investors greedy. The goal of investing is to maximize one’s return on investment. So, it is just good business to invest in the endeavor that provides the highest return.

What these men did was play on the risk versus return equation. We all want low risk investments with high returns. This is typically counter to the reality of investing, which is the greater the risk, the greater the potential reward and conversely the lower the risk, the lower the potential reward. By establishing credibility and consistency, they were able to reduce the perceived risk of investing in order to receive better-than-typical returns. They turned the risk vs. reward equation on its head making their investment opportunities seem like a no-brainer. And, that’s how these cons work.

As I wrote earlier, we can learn a lot about decision-making from crooks and conmen. As Ponzi and Madoff taught us, it is quite easy to be misled by a talented influence practitioner.

On the flip side, we can use this information in a positive way. I constantly harp on my clients about the importance of credibility and consistency. If criminals can build massive empires by leveraging these principles, just think what a legitimate business with an honest value proposition can do.

To learn more about Ponzi, read Ponzi's Scheme, by Mitchell Zuckoff.


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