A Ponzi scheme is a fraud in which invested money is pocketed by the schemer and investors who wish to redeem their money are actually paid out of proceeds from new investors.
As long as new investments are expanding at a healthy rate, the schemer is able to keep the fraud going. Once investments begin to contract, as through a run on the company, the house of cards quickly collapses. The scheme gets it name from Charles Ponzi, an Italian immigrant to Boston, who around 1920 came up with the idea of promising huge returns (50% in 45 days) supposedly based on an arbitrage plan (buying in one market and selling in another) involving international postal reply coupons. The profits allegedly came from differences in exchange rates between the selling and the receiving country, where they could be cashed in. Pontzi began with 16 investors in 1919 and his pyramid scheme eventually took in $15 million. In 1920, Mr. Ponzi was convicted of mail fraud and spent several years in jail.
The basic mechanism explaining the success of Ponzi schemes is the tendency of humans to model their actions--especially when dealing with matters they don't fully understand--on the behavior of other humans. This mechanism has been termed "irrational exuberance," coined by economist, Robert J. Shiller, who later wrote a book with that title.
Mr. Shiller employs a social psychological explanation that he terms the "feedback loop theory of investor bubbles." Simply stated, the fact that so many people seem to be making big profits on the investment, and telling others about their good fortune, makes the investment seem safe and too good to pass up.
In Mr. Shiller's view, all investment crazes, even ones that are not fraudulent, can be explained by this theory. Two modern examples of that phenomenon are the Japanese real estate bubble of the 1980s adn the American dot-com bubble of the 1990s.
While social feedback loops are an obvious contributor to understanding the success of Ponzi and other mass financial manias, one also needs to look at factors located in the dupes themselves. There are four factors used to understand acts of gullibility: situation, cognition, personality and emotion. Obviously, individuals differ in the weights affecting any given gullible act.
Situations. Every gullible act occurs when an individual is presented with a social challenge that he has to solve.
Cognition. Gullibility can be considered a form of stupidity, so it is safe to assume that deficiencies in knowledge and/or clear thinking often are implicated in a gullible act.
Personality. Gullibility is sometimes equated with trust, but the late psychologist Julian Rotter showed that not all highly trusting people are gullible. The key to survival in a world filled with fakers or unintended misleaders who were themselves gulls is to know when to be trusting and when not to be.
Emotion. Emotion enters into virtually every gullible act. In the case of investment in a Ponzi scheme, the emotion that motivates gullible behavior is excitement at the prospect of increasing and protecting one's wealth.
Source: The Wall Street Journal, January 4, 2009
Read an excerpt from Stephen Greenspan's new book, "Annals of Gullibility" at www.WSJ.com/Lifestyle
Stephen Greenspan: Annals of Gullibility: Why We Get Duped and How to Avoid It