Pyramid Scheme

Loading the player...

What is a 'Pyramid Scheme'

A pyramid scheme is an illegal investment scam based on a hierarchical setup. New recruits make up the base of the pyramid and provide the funding, or so-called returns, the earlier investors/recruits above them receive. A pyramid scheme does not involve the selling of products. Rather, it relies on the constant inflow of money from additional investors that works its way to the top of the pyramid.

BREAKING DOWN 'Pyramid Scheme'

An individual or a company initiates a pyramid scheme by recruiting investors with an offer of guaranteed high returns. As the scheme begins, the earliest investors do receive a high rate of return, but these gains are paid for by new recruits and are not a return on any real investment. From the moment the scam is initiated, a pyramid scheme's liabilities begin to exceed its assets. The only way it can generate wealth is by promising extraordinary returns to new recruits; the only way these returns receive payment is by getting additional investors. Invariably these schemes lose steam and the pyramid collapses.

Basic Pyramid Scheme

A pyramid scheme is a variation of the Ponzi scheme, which offers a promise of high investment returns that are not available from traditional types of investment. In practice, the structure of pyramid schemes induces others to recruit victims and collect money that eventually makes its way to the top of the pyramid. In a typical setup, one person recruits a second person to invest a certain amount of money. The second person recovers his investment by recruiting people under him to invest in the scheme. The more people he can recruit under him, the greater his profit and a certain percentage of the profits of all recruiters work their way up the pyramid to enrich the recruiters before him. Each person must recruit a certain number of people. The process continues until there are fewer people at the bottom of pyramid, and it collapses under its own weight. Generally, only the people near the top of the pyramid make any significant profits, and people near the bottom never recover their investments.

Business Pyramids

On their face, multi-level marketing companies are structured like a pyramid. Individuals have the opportunity to invest in their own businesses, which, ostensibly, distribute a product. However, with some companies, the real profit opportunity comes not from selling products but from inducing others into buying into their own business, with a percentage of the investment moving up the hierarchy of recruiters. Among the more high-profile multi-level marketing companies to be investigated as a pyramid scheme is Herbalife Ltd. Herbalife distributors can make money just by selling the company’s products, but they must purchase and sell thousands of dollars' worth of the products before they realize a profit. Critics allege that the company's top recruiters receive the vast majority of profits.

RELATED TERMS
  1. Investment Pyramid

    A portfolio strategy that allocates assets according to the relative ...
  2. Multi-Level Marketing

    A strategy that some direct sales companies use to encourage ...
  3. Ponzi Scheme

    A fraudulent investing scam promising high rates of return with ...
  4. Pyramiding

    A method of increasing a position size by using unrealized profits ...
  5. Affinity Fraud

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

    A fraudulent investment scheme that purports to deliver extraordinarily ...
Related Articles
  1. Trading

    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. Entrepreneurship & Small Business

    Multi-Level Marketing

    Learn how to differentiate between a legitimate marketing strategy and a pyramid scheme.
  3. Markets

    What Is A Pyramid Scheme?

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

    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 ...
  5. Managing Wealth

    Are Headhunters Worth It?

    Some recruiters and recruiting firms use more methods to source suitable candidates than others do.
  6. Trading

    Pyramid Your Way To Profits

    This strategy involves scaling into profitable investments as they continue to rise.
  7. Managing Wealth

    7 Ways To Make Executive Recruiters Notice You

    Yes, you can go after executive recruiters – but take a sophisticated approach. Here's how.
  8. Markets

    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.
  9. Financial Advisor

    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.
  10. Markets

    Investment Scams: Different Types Of Scams

    Very few of the scams on the Internet are new. Most of the swindling techniques we see today originated long ago as telemarketing, direct mail, or even door-to-door selling schemes. But the ...
RELATED FAQS
  1. What is the difference between a Ponzi and a pyramid scheme?

    Pyramid schemes and Ponzi schemes share many similar characteristics in which unsuspecting individuals are fooled by unscrupulous ... 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. How does Jeff Weiner make money from LinkedIn?

    Discover how LinkedIn CEO Jeff Weiner has revolutionized the recruiting industry while creating major revenue from user information ... Read Answer >>
  4. 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 >>
  5. How do I find out my own risk tolerance?

    Learn why risking capital can be risky business, how much risk can you afford and how to determine the right amount of risk ... Read Answer >>
  6. How does a pump and dump scam work?

    A pump and dump scam is the illegal act of an investor or group of investors promoting a stock they hold and selling once ... Read Answer >>
Hot Definitions
  1. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  2. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  3. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  4. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  5. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
  6. Enterprise Value (EV)

    A measure of a company's value, often used as an alternative to straightforward market capitalization. Enterprise value is ...
Trading Center