Naturally, there is always some degree of risk involved with any investment. However, the risk is greatly increased in cases where the investor becomes unexpectedly involved in Ponzi or pyramid schemes, which are illegal in most countries. So, being able to identify these schemes and to understand how they work is of great importance.
What is a Ponzi scheme?
Ponzi schemes are named after Charles Ponzi, an Italian swindler that moved to North America and became famous for his fraudulent money-making system. In the early 1920s, Ponzi managed to defraud hundreds of victims and his scheme – which ran for over a year. Basically, a Ponzi scheme is a fraudulent investment scam that works by paying off older investors with money collected from new investors. The problem with such a scheme is that investors on the backend will not be paid at all.
A Ponzi scheme in operation would look somewhat like this:
A promoter of an investment opportunity takes $1000 from an investor. He promises to repay the initial value along with a 10% interest at the end of a predefined period (e.g., 90 days).
The promoter is able to secure two additional investors before the 90 day period is complete. He will then pay $1100 dollar to the first investor from the $2000 collected from investors two and three. He will also likely encourage the first investor to reinvest the $1000.
By taking the money from new investors, the impostor is able to pay the promised returns to the early investors, convincing them to reinvest and to invite more people.
As the system grows, the promoter needs to find more new investors to join the scheme. Otherwise, he will not be able to pay the promised returns.
Eventually, the scheme gets unsustainable and the promoter either gets caught or disappears with the money he has on hand.
What is a pyramid scheme?
A pyramid scheme (or pyramid scam) operates in the business sector as a model that promises payments or rewards for members that not only join the scheme but also manage to enroll new members.
For example, a fraudulent promoter offers Alice and Bob the chance to purchase distributorship rights in a company for $1000 each. So now they have the right to sell distributorships themselves, earning a share from every additional member they manage to recruit. The $1000 collected from their own sales of distributorships is then shared with the promoter at a 50/50 split.
In the scenario above, Alice and Bob would have to sell two distributorships each to break even, since they earn $500 per sale. The burden to sell two distributorships to recoup the initial investment is then passed on to their customers. The scheme eventually falls apart, since more and more members are needed to continue the process. The unsustainable progression of the scheme is what makes pyramid schemes illegal.
Most pyramid schemes do not offer a product or service and are maintained solely by the money raised from the recruitment of new members. However, some pyramid schemes may be presented as legitimate multi-level marketing (MLM) company that purports to sell a service or product. But they usually do that just to hide the underlying fraudulent activity. Therefore, many MLM companies with questionable ethics are using pyramid models, but not all MLM companies are fraudulent.
Ponzi vs. pyramid
Both are forms of financial fraud that convince the victims to invest money by promising good returns.
Both need a regular inflow of new investors’ money in order to be successful and remain active.
Usually, these schemes do not offer real products or services.
Ponzi schemes are usually presented as investment management services, where participants believe that the return they will gain is a result of a legitimate investment. The impostor basically robs one to pay the other.
Pyramid schemes are based on network marketing and require participants to recruit new members in order to earn money. Therefore, each participant takes a commission before forwarding the money to the top of the pyramid.
How to protect yourself
Be skeptical. An investment opportunity that promises quick or high returns, with minimal investment, is probably dishonest. This is especially true when investing in something that is totally unfamiliar or difficult to understand. If it sounds too good to be true, it probably is.
Beware of unsolicited opportunities. An unexpected invitation to take part in a long-term investment opportunity is usually a red flag.
Investigate the seller. The entity promoting the investment opportunity should be investigated. A reputable financial advisor, broker, or brokerage company, will be registered and monitored by the proper governing bodies.
Do not trust. Verify. Legitimate investments should be legally registered. The first course of action is to ask for the registration information. If the investment opportunity is not registered, a good and reasonable explanation should be provided.
Make sure you understand the investment. You should never invest money in something you do not fully comprehend. Make sure to make use of the resources available and be very cautious with investment opportunities shrouded in secrecy.
Report. Whenever investors encounter a pyramid or Ponzi scheme, it is important to report these to the appropriate authorities. This will help to protect future investors from falling victim to the same scam.