Ponzi schemes are one of the oldest investment frauds, yet as the Bernard Madoff scandal demonstrates, their appeal never wanes. How do they work?

What is a Ponzi scheme?
The classic Ponzi scheme is elegantly simple. Named after Carlo Ponzi, an Italian who immigrated to Boston in the early 20th century, it’s a variation on the classic pyramid scheme, which works by promising—and for a time delivering—spectacular returns on investments. The scheme’s operator, sitting atop the pyramid, starts by bringing in a small number of investors and paying them “dividends,” using the money that comes in from the next round of investors—and continuing the pattern with later investors. The operator either skims money all along or waits until he thinks he’s about to max out and then absconds with the funds. What all Ponzi schemes have in common, besides robbing Peter to pay Paul, is “a three-step playbook: splash, cash, and dash,” said Mitchell Zuckoff, author of a biography of Ponzi. “That is, make a big impression, grab as much cash as possible, and disappear before being exposed.”

What was Ponzi’s scam?
He told investors that he could double their money in 90 days by buying and selling European postage stamps. As the money began to pour in from suckers who believed him, Ponzi used their cash to deliver the returns he had promised to his early investors. They told their friends about a way to make big money quickly and with no risk, and the feeding frenzy was on. At one point, Ponzi was able to raise $1 million, a small fortune back then, in just three hours. He actually had bought only $30 worth of stamps, though, and after nine months, it all came crashing down—but not before thousands of investors, most of them Italian immigrants like himself, were bilked out of $15 million.

Did Ponzi invent this ruse?
No. Historians say versions of the scam first appeared in the 17th century. In one of the earliest schemes in the U.S., in 1899 a New York City grifter named Charles Miller promised stock market investors annual returns of 520 percent. He pocketed nearly $20 million in today’s dollars before he was exposed. Since then, Ponzi schemes have flourished from Romania to the Philippines. In the 1990s, two-thirds of the population of Albania poured $1.2 billion into Ponzi schemes, some of which were endorsed by government officials. When the schemes collapsed in 1997, the country was torn by rioting, the government was toppled, and the U.N. had to send 7,000 troops to restore order.

Why are so many people fooled?
Greed is part of the explanation, but not the entire one. In addition to the belief that you can get rich without work or risk, Ponzi schemes also exploit peer pressure and the herd mentality to reel in the suckers. In 1995, John Bennett, a Philadelphia businessman who loudly proclaimed his Christian faith, recruited investors from Christian organizations by promising to double their money in six months. As with Ponzi, because Bennett’s investors saw him as one of their own, they trusted him. Some lost their entire life savings. Religious groups, in fact, are a favorite hunting ground for financial predators. “I’ve seen more money stolen in the name of God than any other way,” says securities regulator Deborah Bortner.

What about Bernard Madoff?
Madoff, too, traded on his membership in a religious community. Many of his investors were wealthy Jewish philanthropists whom he met at charitable events or at a Palm Beach country club. Madoff claimed he could earn steady returns of 10 percent to 15 percent a year using a secret stock-trading strategy. (In fact, Madoff may never have made a single trade.) And he added a clever twist. Unlike most Ponzi promoters, Madoff ran his so-called hedge fund like an exclusive club. By threatening to turn away would-be investors, he only increased their appetite to invest. Madoff raised as much as $50 billion, allegedly paying out some of the money as dividends to maintain the fiction, donating millions more to nonprofits, and spending much of the rest on real estate, jewelry, and high living.

Why can’t a Ponzi scheme run forever?
Eventually, the fraud who’s running the scheme runs out of suckers, either because the pool of potential investors is exhausted, or because investors begin to smell a rat and demand their money back. “The fuel of a Ponzi is cash infusion,” says lawyer Michael Goldberg. Madoff’s undoing was the worldwide financial crisis, which prompted many investors to try to liquidate. He was unable to bring in the funds to meet the redemption requests, and his house of cards collapsed.

How can you spot a Ponzi scheme?
By asking the right questions. Among them: Is one of the “Big Four” accounting firms auditing your finances? Madoff’s auditor was a virtually unknown three-person accounting firm operating out of a strip mall. Investors should also ask if the fund’s assets are held by an independent third-party custodian who can verify that they actually exist. Madoff had no custodian. Finally, beware of any fund that produces steady returns regardless of whether the market is up or down. No one is that consistent—even Warren Buffett hits rough patches. Ultimately, the old cliché applies: If something sounds too good to be true, it probably is.

The gullible professor
The irony is almost too rich: A psychology professor, about to publish a book about human gullibility, invests a good chunk of his retirement savings with Bernard Madoff and loses it all. That’s what happened to Stephen Greenspan, author of Annals of Gullibility: Why We Get Duped and How to Avoid It. Detailing his misadventures in The Wall Street Journal, Greenspan said it started when his sister and some of her friends, all longtime Madoff investors, urged him to get in on a good thing. They “convinced me that I would be foolish not to take advantage of this opportunity,” Greenspan writes. He was so eager to believe, that when a financially savvy friend warned him against the investment, Greenspan dismissed the warning as “knee-jerk cynicism.” Only self-deception, Greenspan says, can account for the foolish choices made by otherwise intelligent people. “They had too good a thing going,” Greenspan says, “to entertain the idea that it might all be about to crumble.” And as long as humans remain prey to self-deception, Ponzi schemes will continue to succeed—until they collapse.