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, but both can be devastating if broken down.

Ponzi Schemes

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.

The most famous Ponzi Scheme in recent history–and the single largest fraud of investors in the United States–was orchestrated over a period of over a decade. He built a large network of investors that he raised cash from, pooling his almost 5,000 clients' money into an account he withdrew from. He never actually invested the money, and the SEC values the total loss to investors to be around $65 billion.

Pyramid Schemes

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.

Although pyramid schemes are harder to prove than Ponzi schemes. They are also better protected because the legal teams behind corporations are much more powerful than those protecting an individual. One of the largest accuses pyramid schemes was with the nutritional company Herbalife (NYSE: HLF). Even though they were labeled as an illegal pyramid scheme and paid out more than $200 million in damages their products still sell, and the stock price looks healthy.

How to Protect Yourself

Just as you should be investigating companies whose stock you purchase, it is equally as important to investigate those who manage your money for you–even if they are a close friend. Calling the SEC to ask if they have open investigations or prior instances of fraud is helpful. Also, they should be able to offer verifiable financial data. If these are investments they can be easily checked. If you are considering investing into what appears to be a pyramid scheme, it would be beneficial to use your lawyer or CPA to peruse the documents for inconsistencies.

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.