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. Why was the accountant responsible for auditing ZZZZ Best unable to determine that ...

    Find out why the accountant responsible for auditing ZZZZ Best couldn't determine that the company was engaged in a Ponzi ... Read Answer >>
  3. Why don't investors buy stock just before the dividend date and sell right afterwards?

    Many years ago, unscrupulous brokers would use the same logic on their clients as a sleazy sales tactic. These brokers would ... Read Answer >>
  4. Can investors short sell pink sheet or over-the-counter stocks?

    Short selling is an effective trading strategy that can be employed to hedge the risk of a loss on an off-setting position ... Read Answer >>
  5. What are the advantages of hiring a third-party marketing company?

    Explore the advantages of using a third-party marketing service to drive a marketing campaign. Like with most marketing strategies, ... Read Answer >>
  6. What was "Operation Wooden Nickel"?

    On November 19, 2003, the Commodity Futures Trading Commission (CFTC) and the FBI announced the completion of an 18-month ... Read Answer >>
Related Articles
  1. 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.
  2. Investing

    What Is A Ponzi Scheme?

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

    What Is A Pyramid Scheme?

    Find out how this financial scam works and why you should watch out.
  4. Insights

    The 5 Worst Financial Advisor Scammers of All Time

    A look back at history's five worst financial scams.
  5. 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.
  6. 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.
  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. Trading

    Pyramid Your Way To Profits

    This strategy involves scaling into profitable investments as they continue to rise.
  9. Small Business

    Multilevel Marketing Isn't Always A Scam, But It Often Is

    Nerium and Amway are popular direct sales companies that recruit new buyers and sellers to make a profit. Sadly, many direct sales firms are scams.
RELATED TERMS
  1. Ponzi Scheme

    A fraudulent investing scam promising high rates of return with ...
  2. Ponzi Mania

    The seemingly sudden recognition of Ponzi schemes following the ...
  3. High-Yield Investment Program - HYIP

    A fraudulent investment scheme that purports to deliver extraordinarily ...
  4. Mini Madoff

    Financial con men that are accused of or have commited crimes ...
  5. Pump And Dump

    A scheme that attempts to boost the price of a stock through ...
  6. Wire Fraud

    A situation where a person concocts a scheme to defraud or obtain ...
Hot Definitions
  1. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless ...
  2. Buyback

    The repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies ...
  3. Tax Refund

    A tax refund is a refund on taxes paid to an individual or household when the actual tax liability is less than the amount ...
  4. Gross Domestic Product - GDP

    The monetary value of all the finished goods and services produced within a country's borders in a specific time period, ...
  5. Inflation

    The rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of ...
  6. Merchandising

    Merchandising is any act of promoting goods or services for retail sale, including marketing strategies, display design and ...
Trading Center