Decoder: Ponzi Scheme vs Pyramid Scheme

Ponzi and pyramid schemes have many similar characteristics based on the same concept: unsuspecting individuals get fooled by unscrupulous investors who promise them extraordinary returns in exchange for their money. Unlike a regular investment, these schemes can offer consistent profits only as long as the number of investors continues to increase. Once the number tapers off, so does the money.

Ponzi and pyramid schemes are self-sustaining as long as cash outflows can be matched by monetary inflows. The basic differences arise in the type of products that schemers offer their clients and the structure of the two ploys, but both can be devastating if broken down.

Ponzi Schemes

Ponzi schemes are based on fraudulent investment management services. They promise investors higher returns than traditional investments by paying returns to investors from money taken from new investors.

Here's how it works. Investors contribute money to the portfolio manager (the person running the scheme) who promises them a high return. When those investors want their money back, they are paid out with the incoming funds contributed by later investors.

The person who organizes this type of fraud is in charge of controlling the entire operation. But rather than put the money into a type of investment that earns interest, they merely transfer funds from one client to another and forgo any real investment activities.

Warning Signs of a Ponzi Scheme

So how do you know if you're involved in a Ponzi scheme? There are several telltale signs, including:

  • Promises of high returns. Be wary if your portfolio manager makes claims that your profits will net you substantially higher returns than those of traditional investments.
  • Little to no risk. Every investment offers some degree of risk. So there should be some alarm bells when someone says you'll be completely shielded and your money is protected.
  • Lack of registration and licenses. Legitimate investments are regulated and managers are licensed. Make sure you ask to see any documents and credentials of anyone who is offering big results for your money.
  • Complicated investment strategies. If you can't understand how your money generates returns, it's probably too good to be true.
  • Missing paperwork and payments. You should be concerned if you aren't receiving any statements and/or if you don't get the payments that you're promised.

Pyramid Schemes

A pyramid scheme works a little differently than a Ponzi scheme. This scheme is structured so that the initial schemer must recruit other investors who will continue to recruit other investors, and those investors will then continue to recruit additional investors, and so on.

People at the top of the pyramid tend to profit the most. And because they earn more money, they're able to entice more people to join. As more people join, more money finds its way into the pyramid, which gets funneled in from new investors to the people higher up. But those at the bottom lose out, especially if they can't get others to join.

There may sometimes be an incentive that is presented as an investment opportunity, such as the right to sell a particular product or multilevel marketing (MLM). Each investor pays the person who recruited them for the chance to sell this item. The recipient must then share the proceeds with those at the higher levels of the pyramid structure.

Warning Signs of a Pyramid Scheme

You may be able to guess when you're in a pyramid scheme if the following is true:

  • Recruitment. This is the main way of drawing people into the scheme. And you can't join (and thus, earn money) unless you pay a fee. In most cases, you'll also be promised more money if you recruit others.
  • Fast cash. Most pyramid schemes promise to pay you big returns in a short amount of time. In many cases, these returns usually come from money paid by new recruits.
  • Passive income. There are many schemes that promise to pay you money without any actual work. Again, this money is almost always coming from new recruits to the pyramid.
  • Lack of documentation. Like the Ponzi scheme, there is almost never any documentation that proves how the revenue is generated. Be sure to ask for financial statements, which should be audited by a financial professional.
  • Hard to understand the commission structure. If you can't understand where your profits are coming from or how anyone in the scheme is paid, then it's probably too good to be true.

Key Differences

Ponzi and pyramid schemes are both similar investment frauds perpetrated by one or more individuals seeking personal gain. They both involve deceiving others by promising substantial income or returns on an investor's initial investment. But there are inherent differences between the two.

One key difference is that pyramid schemes are harder to prove than Ponzi schemes. They are also better protected because the legal teams behind corporations are much more powerful than those protecting an individual.

Another thing that sets these two types of schemes apart is that the Ponzi scheme only requires investors to put up their money in exchange for returns. Pyramid schemes, on the other hand, require investors to pay a fee or purchase products in order to participate and earn returns.

Article first appeared on Investopedia.

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