Pyramid Schemes and Ponzi Schemes
In a typical pyramid scheme you are approached by someone, possibly even a personal friend, inviting you to join a marvellous scheme to make money. You invest cash into the scheme and then invite other people to join. When a certain number of people have joined the scheme you will progress up until eventually you reach the top.
At this point you get a pay-out from the money invested by the people underneath you (after that the people underneath you get to the top and they’ll receive a payout, and so on). However most people never get to this level.
The promoters of this sort of scheme (which is sometimes called a ‘gifting scheme’ or ‘gifting tree’) usually try and explain that there is a loophole in the law that means that their scheme is not a pyramid scheme at all and is therefore totally legal. For example, they will claim that if a donation is made to charity this makes the scheme legal. Pyramid schemes are illegal and there are no such loopholes.
Sometimes these schemes are sold as being about empowerment and people helping one another. In recent years there have been pyramids specifically targeting women, suggesting that being part of the scheme bonds them into a sisterhood who have found a way to financial independence by ‘gifting’ money to one another. These are strategies designed to appeal to your emotions and make you feel good, in the hope that this will stop you thinking about how the scheme actually works and how it is mathematically guaranteed to fail.
Alternatively a pyramid scheme will make it look like each person is starting a business, for example selling a product, and that you should recruit people to join the scheme underneath you who will pay you commissions and/or fees (these recruits are then supposed to bring in new people under them, and so on).
You may be asked to pay a significant joining fee and you will almost certainly need to buy a large amount of the ‘product’ that you are supposed to be able to sell on (although you may well find nobody actually wants to buy this product, often because the price you’d have to sell it at to make a profit is way ahead of the market average). Close inspection reveals that the only way to make money is for an ever increasing number of people to be recruited underneath you, as few (if any) people will be able to sell enough of the product to make it worthwhile on its own.
A common term used to obscure the pyramid structure is ‘multi-level marketing’ or ‘MLM’. Many schemes that use a MLM structure are legal and perfectly legitimate (such as Tupperware or Avon), but others are not and are actually Pyramid Schemes in disguise. If you must buy a certain amount of product (rather than what you need) or your participation and any chance of making a profit relies on you finding more recruits, it’s likely it’s a pyramid scheme rather than a legitimate MLM.
Real MLM companies are genuinely interested in getting their products to consumers, as this is where the main profit is generated for both the parent company and the agent. As a result they normally offer a lot of support to their sellers. Pyramid schemes are more interested in getting new people to pay joining fees and start-up costs than actually selling the product they are supposedly there to market.
As a result it’s more important to look at the back-end support and possible losses if you never sell anything (and you never get any recruits) than the profits any scheme promises, as even in legitimate MLM schemes these headline figures may be a lot more than you as an individual can achieve. If it sounds too good to be true, it almost certainly is.
Bound To Fail
Remember, no matter how ‘foolproof’ one of these enterprises may seem, Pyramid schemes only work if there are an infinite number of investors, which of course is impossible. For example, if in a Pyramid scheme each person needs to recruit three others, at just 16 levels down from the top, every person in Britain would need to be involved and funnelling money up the pyramid so that it didn’t collapse.
The power of these schemes is that they sound very simple and appealing. You just need to invest and then find a few more people to invest – and everyone will get rich. It’s only when you look at the maths that you realise that if everyone needs to find a few recruits (and their money), you will run out of people much faster than it might first appear. After all, if you double the number 1 just 33 times, you’ve already reached a number larger than the entire population of the earth.
Small Pyramids Are Just As Dangerous
Even if a scheme is sold as only having a few levels before the top person is paid out and leaves the schemes (and it therefore seems less risky), remember that each person recruited also starts their own pyramid, so you still need an ever growing pool of recruits and the risk is still the same (take a look at the graphic below to see how quickly these schemes can escalate).
Your pyramid may only have a few people, but there may also be many other related pyramids within the overall scheme, all of which also need new recruits to keep going. Indeed these smaller pyramids can be rather insidious, as often many will collapse causing widespread losses, but because a few will succeed, the scheme can continue on for at least a little longer while a new bound-to-fail network is built.
No matter how it’s sold to you, most people – up to 90% by some estimates – in a pyramid scheme will lose money.
Pyramid schemes recruit all their victims into being further promoters of the scheme to their personal contacts. When the scheme collapses the investors find that they have not only lost their own money but been responsible for their family and friends losing money as well. Entire communities have been ripped apart by these schemes, so be very careful if one of your relatives or friends approaches you with a business/financial proposition, even if it initially sounds legitimate.
Also be aware that if they have approached you with a pyramid scheme, they may not realise that’s what it is. Part of this sort of scam’s enduring power is that they con people into thinking they’re both helping themselves and those they recruit. No one, except the people at the top organising it, is deliberately trying to defraud anyone else, even if it sometimes seems that way when it all collapses.
As with any business proposition, always question where and how profits are being generated. In a pyramid scheme no (or at least very little) real money is made as it’s simply being passed up the pyramid by new recruits (on the promise that in the future these newcomers will get some passed up to them). As no one is actually doing anything to make money and you need ever more cash/recruits coming in at the bottom so that everyone will be paid as promised, it is inevitably unsustainable and most people will lose out.
While the terms Ponzi Scheme and Pyramid Scheme are sometimes used interchangeably, a Ponzi Scheme tends to refer to enterprises where a dodgy business or individual hides the flow of money from the investors, so it doesn’t look like a pyramid. It also differs in that while a pyramid relies on people directly recruiting others, in a Ponzi scheme there is one central person/company everyone deals with. The end result is the same though, because as with a pyramid scheme, it can only keep going with a constant flow of new investors/money, and relies on ‘robbing Peter to pay Paul’ to suggest profits are being made.
The classic example is a dodgy financial firm that promises investors a large profit after a fixed term. The first people who sign up are given exactly what the firm said they would – often a 50% or 100% profit in a relatively short space of time. This apparent success then attracts more investors, as well as enticing the old investors to put more cash into the company in the hope of further profits.
In reality, the profits for the initial backers comes from the money put into the company by the new investors, not by money generated from actual successful investments or business activities. These schemes often go on for much longer than pyramid schemes (which can build and collapse in just a few weeks). Ponzi schemes can continue as long as more new money is coming in than old money is being taken out. It also helps that due to the stated (yet fictitious) profits, people often keep their money invested, not realising that their cash isn’t really growing at all. Instead it may have been paid out to other investors or siphoned off by the people running the Ponzi scheme.
It’s also been known for legitimate firms (and not just financial investment firms) to become illegal Ponzi Schemes when they run into financial trouble. They try to hide their problems by pretending that they have more money and fewer losses than they actually do, using new money coming in to pay off old debts (without saying that’s what they’re doing). This is usually done in the hope they’ll be able fill in the hole in their finances before anyone notices and that they’ll then go back to being a legitimate business. If they can’t plug the gap, continued fraud becomes the only way the company can keep trading.
At some point these schemes will collapse though, either after the fraud is discovered; when the supply of new money runs out; or if the person running the scheme embezzles the remaining cash and disappears.
The Biggest Financial Fraud In US History
One of the most famous examples of a Ponzi scheme is the one operated in the US by Bernie Madoff from at least the early 1990s until 2008. He ran a very similar financial investment scheme to the example above, convincing people he could offer unusually steady and high profits. In reality he simply put his clients’ funds into a bank account rather than properly investing it. Then when payouts were requested, he would use other people’s money to honour that.
He got away with it for decades by producing false accounting statements that said people’s investments were doing exceptionally well (although not so spectacularly well it might have raised red flags). As clients thought he was doing a good job, most left their ‘money’ with him, while new investors were continually attracted in. The scheme collapsed during the 2008 financial crisis when panicking investors suddenly wanted to withdraw $7 billion in funds, and Madoff didn’t have the cash to cover that.
In total, there was $65 billion less in investors’ accounts than their fabricated statements had said, with $18 billion of actual losses. Madoff was sentenced to 150 years in prison. It has been described as the largest individual financial fraud in US history
Madoff’s example is particularly important as he relied on individuals, charities and those with little experience of investments to build his empire, promising them riches coming from things they didn’t fully understand. Large Wall Street companies, funds and others with lots of experience steered clear of him, as they didn’t trust his numbers, but Madoff was adept at conning normal people into giving him their cash, relying on the fact that they didn’t actually understand the things he said he could do. Instead they mainly just looked at the (fictitious) numbers he said he could achieve.
Research Any Investments Thorougly
Before making any investment, do as much research as possible so you fully understand what you’re doing and what companies you are dealing with. It’s better to make a little less money but know your cash is as safe as it can be, than to possibly lose it all to a con – which is as true of Ponzi schemes as it is of Pyramid schemes.
Always be wary of any investment or business opportunity that promises returns massively ahead of the general market, unless they have exceptionally solid reasons to believe they can achieve those returns.
Recent examples of Ponzi-type schemes targeting consumers include certain ‘investment clubs’ for products such as fine wine. While some of these clubs are legitimate, others are aware the products they’re inviting people to invest in will never rise in price the way they suggest. However, by paying out large profits to early recruits anyway (or at least saying the investment has jumped in value), they pull in both new investors and convince the original people to reinvest, normally asking for more cash second time around. They often also suggest that investors should try to get their friends and family involved so they can all share the wealth.
When the scammers can’t hide it anymore or they feel they can’t pull any more cash from their current investors, it’s discovered the ‘wine’ is either worthless or was never purchased in the first place, and the scammers have disappeared. In some cases investors have been further stung by being told they still have to pay inflated storage fees for the worthless wine, as that’s what they agreed to in their contract. While this is not true of all ‘investment clubs’, be very careful when invited into ventures like this, especially if you will be investing in a product or area you don’t fully understand.