What is Ponzi scheme and pyramid scheme? What is the difference between them? How to avoid it?

▪ Natalie’s story

Miss Natalie Naive was invited for lunch by her friend Peter Pseudo investor. They discussed many things, but then Peter revealed the true nature of his invitation:

„Look Natalie, my trusted friend had recommended me a Golden Fields Fund. You can invest your savings there, and gain 100% profit a year, with quarterly payout! I’ve already got my first payout, and I think this is a great way for you to double your savings. You should invest too – the more, the better.”

Natalie tempted with high profits, took Peters advice and invested all her savings in Golden Fields Fund. While in a meeting with fund representatives, he repeated many times, that she should convince her friends and family to also invest money in the fund. He appealed to her conscience and told her that she should give her family and friends a chance to get rich, because such a chance does not come often.

Due to the persuasion of representatives, which had made a very good impression upon her, Natalie convinced many of her friends and family, to invest money in the fund, where she herself had invested everything she could, understandably, she couldn’t wait to see the profits.

Two months later, before she got her first payout, she watched the news, and her heart sank. It turned out, that the fund was a fraud, and that she probably wouldn’t get any money back. The fund owner disappeared, and Natalie had realized, all too late that it was a Ponzi scheme. What’s worse, she got her friends and family involved as well. In this way, Natalie lost her life savings, and the trust of those close to her.

▪ The difference between Ponzi scheme and pyramid scheme

You often hear, the names Ponzi scheme and pyramid scheme as if they were interchangeably, yet there is a difference between them.

In Ponzi schemes, all the money goes to the creator of the scheme, and they pay out some percentage to people on lower levels of the scheme if agreed upon beforehand. In pyramid scheme however, people in every level of the scheme yield direct profits from the lower levels they acquired and pay some percentage to the people in higher level.

What is similar, is that both need a growing supply of new members for the scheme to function. If there are more payments than withdrawals, everything seems ok. But from the very beginning both are doomed to fail, because there is no chance to acquire funds indefinitely.

Ponzi Scheme

As you can see in the chart – if every person in the scheme were to acquire six other members – on the 10th level of the pyramid, the number of members would exceed the population of a medium sized country like Poland, and on the 13th level, the number of members would exceed the world population nearly two times. For that reason, the schemes lifespan is usually very short.

▪ Various forms of schemes

Pyramid and Ponzi schemes can take different forms as well.

They can present themselves as big investment companies, that invest in assets and offer very high yields in short periods of time. In reality, however, the assets aren’t bought, and the payouts for the former investors are paid from the deposits of the new ones. The best example of such an action is Charles Ponzi, from whom the Ponzi scheme derives its name. The assessed loses of the deceived clients was $15 million USD.

Another example of a Ponzi scheme is the actions of Bernie Madoff, the creator of one of the most well-known Ponzi schemes in the world, due to longevity of the scheme, public figures among clients and loses assessed to $64,8 billion USD. We encourage you to read their stories, to avoid history repeating itself.

Charles Ponzi
Bernie Madoff

The schemes can take the form of advertisements presenting a perspective of high paid work from home, and “all you have to do” to start earning, is to buy a very expensive starter package, which then turn out to be worthless.

The schemes can also pretend to be Multi Level Marketing businesses, but the profit you make depends almost entirely on the people you’ll recruit to work for you, or those who buy the starter package. The scheme differs from legitimate MLM business, which sell genuine products, and do not require new members to exist.

Pyramid schemes can also take the form of chain letters, where people ask to pay small amount of money to people on mailing lists, and then to add your own data to the list and send it to as many people as you can.

▪ What to watch out for

Of course, the list isn’t complete. You should avoid any activity, in which your profit depends only on new members payments, and watch out for any situations promising a “miraculous occasion”, where someone promises you high gains in short periods of time after paying a starting fee.

In case of financial institutions, you should always demand clear information about the ways companies invest, and what assets they buy. You shouldn’t trust high gains without risk, or “secret methods of investing”.

A company’s business model should be transparent. There must be a justification for high gains, and the risks should be explained to you. There are no shortcuts unfortunately, high gains usually come with high risks.

It’s also worth noting, that in times of speculative mania, which can be the last stage of the bull market, we can also observe something similar to the pyramid scheme at work. Now, just to be clear, we do not say, that the stock market is a scheme. What we mean is that when the stock market prices are far from their fundamentals, prices grow only as long as there are more buyers than sellers.

This situation cannot go on forever, because sooner or later the prices will go back to their fundamentals, and the people who bought their share last in the stock market rally, will lose the most. The bottom line is, that herd instinct is not advised on the stock market. Fundamental analysis is.

▪ Summary

To sum everything up, don’t be afraid to save and invest, but do it wisely, with healthy skepticism.

Scrutinize every opportunity with caution to avoid future problems. Educate yourself about the assets you wish to invest in, because then you’ll be able to know if someone is telling you the truth about the gains and the risks.

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