Pyramid Scheme and Ponzi Scheme

What exactly is a Pyramid Scheme and why are they illiegal? Here’s why these “get rich quick” plans  just don’t work.

Have you ever received an email with a subject line “Make $1 million in 30 days” or some other “Get rich quick” variation? Chances are, you received a chain email, at the heart of which lies a pyramid scheme, a Ponzi scheme, or one of many other fraudulent schemes meant to separate you from your money.

The theme of the email message is something that sounds too good to be true; invest a small amount, say $5, and receive $1 million later. The steps are outlined usually as follows:

Other variations exist, including selling reports or gifts. The structure of people joining the scheme forms a hierarchical system, resembling a pyramid from which it gets its name. Pyramid schemes are illegal in most countries, but many schemes still operate under the cover of another business, or by creating fake products or services.

Such emails may use confusing language, with the intent to make you think it is a multi-level marketing (MLM) scheme. MLM schemes have their share of detractors, but they are legal because they have a product to sell. Examples of successful MLM schemes are Amway, Tupperware and Avon Products. The difference between MLM and pyramid schemes is that pyramid schemes do not offer a genuine product.

So what exactly is a "Pyramid Scheme"? A pyramid scheme is a non-sustainable business model that involves the exchange of money primarily for enrolling other people into the scheme, without any product or service being delivered.

Pyramid schemes do not work for a reason. Take the case of an email that requires you to pass it along to six people. At the first level, six people join, at the second level, 36 join, and so on, increasing exponentially with every level. As shown in the diagram, even if everyone signs up, pretty soon the number of participants exceeds the population of the U.S., and even the world. The people in the last level of the scheme are not able to find anyone to join their scheme, and end up paying out money to the people below them but will not receive anything in return.

The number of participants at each level is more than the sum of all the participants in the levels above it. For our example of six people, the ratio of people who lose money is five to one. So, in such a scheme, five in every six people, or 84 percent, always lose money.

Ponzi schemes are similar. Ponzi schemes are emails that promise a rate of return of 20 to 30 percent in 30 days on your investment. (Banks have return rates of four to five percent, the stock market of nine to 12 percent.) The schemes usually claim to generate such high rates using global currency arbitrage or high return investment programs. These terms are intentionally vague because usually there is no such mechanism. In fact, Ponzi schemes work by paying back old investors using the money that new investors put in. Then, people who invest at the start spread the word and, more often than not, reinvest their money in the scheme. At some point, however, the scheme cannot sustain itself and collapses. The originators disappear with the money.

It is often hard to distinguish between genuine MLM schemes and pyramid or Ponzi schemes. To make out the difference, consider scrutinizing the following things:

• Is a genuine product offered? If it is just a vague service, chances are, it is a pyramid scheme.
• Try and find information about the company on Google. Are they an established and reputed investment firm?
• Does the body of the email assure you it is legal to join the scheme? True legal ways of making money do not usually have to explicitly state that they are legal.

You should be on the lookout for such schemes. In fact, it may be beneficial to set your email client to use email filters that classify emails with such subject lines as spam. If in doubt, always look up the Securities and Exchange Commission Web site to check for the validity of the scheme.

Image source:Securities and Exchange Commission   

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