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 are some high-profile examples of wash trading schemes?

    In 2012, the Royal Bank of Canada (RBC) was accused of a complex wash trading scheme to profit from a Canadian tax provision, ... Read Full Answer >>
  2. Do negative externalities affect financial markets?

    In economics, a negative externality happens when a decision maker does not pay all the costs for his actions. Economists ... Read Full Answer >>
  3. What is the difference between disposable and discretionary income?

    According to the Bureau of Economic Analysis, or BEA, disposable income is the amount of money an individual takes home after ... Read Full Answer >>
  4. What are the major laws (acts) regulating financial institutions that were created ...

    Presidents George W. Bush and Barack Obama, in conjunction with Congress, signed into law several major legislative responses ... Read Full Answer >>
  5. What are the similarities and differences between the savings and loan (S&L) crisis ...

    The savings and loan crisis and the subprime mortgage crisis both began with banks creating new profit centers following ... Read Full Answer >>
  6. What measures could the U.S. Government take to prevent another crisis similar to ...

    Some of the measures that the U.S. government can take to prevent another crisis similar to the savings and loan (S&L) ... Read Full Answer >>
Related Articles
  1. Professionals

    Holding Out for Capital Gains Could Be a Mistake

    Holding stocks for the sole purpose of avoiding short-term capital gains taxes may be a mistake, especially if all the signs say get out.
  2. Investing Basics

    Toshiba's Accounting Scandal: How It Happened

    Learn how Toshiba's corporate culture and lax internal controls led to an accounting scandal that ended with the resignation of the company's CEO.
  3. Economics

    Is The EU Holding Germany Back?

    As Germany agrees to initiate bailout talks with Greece once again, could all of the EU's economic turmoil result in Germany being better off alone?
  4. Economics

    The Biggest Items Obama Is Still Missing From His Mandate

    Learn how the biggest items missing from Obama's mandate include various forms of tax reform and closing the Guantanamo Bay prison in Cuba.
  5. Professionals

    Is Your Financial Advisor Looking Out for You?

    Financial advisors sometimes aren't looking out for clients' best interests. Regulators are scrutinizing their practices; investors should too.
  6. Economics

    A Comparison Between a Default and a Collapse

    Is the Greek default similar to the Lehman Brothers collapse?
  7. Investing Basics

    Who Is The Next Greece?

    Several EU countries are on the potential candidate list, but some municipalities in the U.S. look far more like Greece. Could they be the “next Greece”?
  8. Bonds & Fixed Income

    Dodd-Frank Creates a Liquidity Crunch for Bonds

    While each individual institution is undoubtedly safer due to capital constraints imposed by Dodd-Frank, this makes for a more illiquid market overall. The lack of liquidity will be especially ...
  9. Economics

    Game Theory And The Greece Bank Crisis

    How can game theory help us understand how the Greece bank crisis will play out? As things come to a head, Greece and the Europeans are trying to hold out.
  10. Stock Analysis

    The 3 Best Buy-and-Hold Stocks For the Next 10 Years

    Find out what makes electric cars, burritos and muscle shirts great buy-and-hold additions to your long-term portfolio.
RELATED TERMS
  1. Black Money

    Money earned through any illegal activity controlled by country ...
  2. Regional Asset Liquidation Agreement (RALA)

    An agreement between an asset manager and the Federal Deposit ...
  3. The New Deal

    A series of domestic programs designed to help the United States ...
  4. Accelerated Resolution Program (ARP)

    A program designed to reduce the time and cost of resolving failed ...
  5. Asset Liquidation Agreement (ALA)

    A contract between the Federal Deposit Insurance Corporation ...
  6. Capital Loss Coverage Ratio

    The difference between an asset’s book value and the amount received ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!