A:

Pyramid schemes and Ponzi schemes share many similar characteristics in which unsuspecting individuals are fooled by unscrupulous investors who promise extraordinary returns. However, in contrast to a regular investment, these types of schemes can offer consistent "profits" only as long as the number of investors continues to increase. Ponzi and pyramid schemes are self sustaining as long as cash outflows can be matched by monetary inflows. The basic difference arises in the type of products that schemers offer their clients and the structure of the two ploys.

Ponzi schemes are based on fraudulent investment management services – basically investors contribute money to the "portfolio manager" who promises them a high return, and then when those investors want their money back they are paid out with the incoming funds contributed by later investors. The person organizing this type of fraud is in charge of controlling the entire operation; they merely transfer funds from one client to another and forgo any real investment activities.

On the other hand, a pyramid 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. Sometimes there will be an incentive that is presented as an investment opportunity, such as the right to sell a particular product. Each investor pays the person who recruited them for the chance to sell this item. The recipient must share the proceeds with those at the higher levels of the pyramid structure.

There are two additional important factors to consider: the only guilty party in the Ponzi and pyramid scheme is the originator of the corrupt business practice, not the participants (as long as they are unaware of the illegal business practices). Secondly, a pyramid scheme differs from a multi-level marketing campaign which offers legitimate products.

For related reading, take a look at What Is A Pyramid Scheme? and The Ghouls And Monsters On Wall Street.

This question was answered by Arthur Pinkasovitch.

RELATED FAQS
  1. What is a risk pyramid and why is it important?

    Learn about the risk pyramid and what it is used for; discover why it is important for investors to use the risk pyramid ... Read Answer >>
  2. How does pyramiding work?

    Pyramiding is a method of increasing margin by using unrealized returns from successful trades. Pyramiding works by surrendering ... Read Answer >>
  3. What are some famous scandals that demonstrate the agency problem?

    Learn more about the agency problem and find a few famous examples. Find out what contributes to these problems and how investors ... Read Answer >>
  4. What kinds of acts pertaining to interests in collective investment schemes are excluded ...

    Learn about some of the kinds of acts related to collective investment schemes that are excluded from regulation as financial ... Read Answer >>
  5. Are so-called self-offering and self-management covered by "Financial Instruments ...

    Learn a little bit about the regulation of Japanese securities, particularly as it pertains to self-offering for investments ... Read Answer >>
Related Articles
  1. Personal Finance

    What Is A Pyramid Scheme?

    The FTC announced it had opened an official investigation of Herbalife, which has been accused of running a pyramid scheme. But what exactly does that mean?
  2. Managing Wealth

    6 Ways to Avoid an Investment Ponzi Scheme

    Investments that promise high returns with little risk are everyone's dream – but if they could also be a Ponzi scheme. Here's how to protect yourself.
  3. Investing

    What Is A Ponzi Scheme?

    Protect yourself from scams by learning the structure behind this fraudulent investing scheme.
  4. Investing

    What Is A Pyramid Scheme?

    Find out how this financial scam works and why you should watch out.
  5. Investing

    Determining Risk And The Risk Pyramid

    Many investors do not understand how to determine the risk level their individual portfolios should bear.
  6. Insights

    The 5 Worst Financial Advisor Scammers of All Time

    A look back at history's five worst financial scams.
  7. Insights

    Recognize And Avoid "Work At Home" Scams

    From pyramid schemes to envelope stuffing, there are a lot of scams masquerading as legitimate part-time work.
  8. Insights

    Are You Sure You Aren't Ponzi Scheme-Susceptible?

    Anyone can be a victim of a Ponzi scheme — even the most financially literate. Here's how to avoid the next Madoff.
  9. Insights

    Affinity Fraud: No Safety In Numbers

    Ponzi schemes are just one example of this type of scam; learn how to avoid becoming a victim.
RELATED TERMS
  1. Pyramid Scheme

    An illegal investment scam based on a hierarchical setup. New ...
  2. Ponzi Scheme

    A fraudulent investing scam promising high rates of return with ...
  3. Investment Pyramid

    A portfolio strategy that allocates assets according to the relative ...
  4. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, ...
  5. High-Yield Investment Program - HYIP

    A fraudulent investment scheme that purports to deliver extraordinarily ...
  6. Multi-Level Marketing

    A strategy that some direct sales companies use to encourage ...
Hot Definitions
  1. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  2. Money Market

    A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. ...
  3. Block (Bitcoin Block)

    Blocks are files where data pertaining to the Bitcoin network is permanently recorded.
  4. Fintech

    Fintech is a portmanteau of financial technology that describes an emerging financial services sector in the 21st century.
  5. Ex-Dividend

    A classification of trading shares when a declared dividend belongs to the seller rather than the buyer. A stock will be ...
  6. Debt Security

    Any debt instrument that can be bought or sold between two parties and has basic terms defined, such as notional amount (amount ...
Trading Center