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. 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 >>
  3. 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 >>
  4. 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 >>
  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 >>
  6. How do mutual funds work in India?

    Find out how mutual funds work in India, including what types of funds are available, how they are structured and how they ... 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. Small Business

    Multi-Level Marketing

    Learn how to differentiate between a legitimate marketing strategy and a pyramid scheme.
  3. 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.
  4. Managing Wealth

    9 Signs That Business ‘Opportunity’ May Be a Scam

    There can be a fine line between a legitimate multi-level marketing opportunity and a pyramid scheme. Here are 9 warning signs.
  5. Investing

    What Is A Ponzi Scheme?

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

    What Is A Pyramid Scheme?

    Find out how this financial scam works and why you should watch out.
  7. Financial Advisor

    The 5 Worst Financial Advisor Scammers of All Time

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

    How To Profit From My Early Call To Short This Overvalued Stock

    It's difficult to admit that I was too early with a market call. It's even harder to accept when I realize I was riding the coattails of a billion-dollar bet made by a renowned activist investor. ...
  9. Investing

    Mutual Funds Vs ETFs

    Learn more on how these collective investment schemes are similiar in design but differ in a few key areas that affect an investor's returns.
  10. Financial Advisor

    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 Mania

    The seemingly sudden recognition of Ponzi schemes following the ...
  3. Affinity Fraud

    A type of investment scam in which a con artist targets members ...
  4. High-Yield Investment Program - HYIP

    A fraudulent investment scheme that purports to deliver extraordinarily ...
  5. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, ...
  6. Multi-Level Marketing

    A strategy that some direct sales companies use to encourage ...
Hot Definitions
  1. Conflict Theory

    A theory propounded by Karl Marx that claims society is in a state of perpetual conflict due to competition for limited resources. ...
  2. Inflation-Linked Savings Bonds (I Bonds)

    U.S. government-issued debt securities similar to regular savings bonds, except they offer an investor inflationary protection, ...
  3. Peak Globalization

    Peak globalization is a theoretical point at which the trend towards more integrated world economies reverses or halts.
  4. Phishing

    A method of identity theft carried out through the creation of a website that seems to represent a legitimate company. The ...
  5. Insurance

    A contract (policy) in which an individual or entity receives financial protection or reimbursement against losses from an ...
  6. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator ...
Trading Center