PYRAMID SCHEME
A pyramid scheme is an illegal business in which investors are paid with monies brought in by later investors. With a pyramid scheme the marketers or tricksters make the scheme real with many types of products or services. So when it gets to a time that they cannot raise enough money from new investors to pay the earlier investors then the pyramid scheme collapses. When it happens this way, many people tend to lose their money.
PONZI SCHEME
A Ponzi scheme is type of investment fraud in which returns are paid to investors either from their own money or out of money paid in by subsequent investors rather than profits generated by investments or any genuine business activity. (Mervyn K. Lewis, 2015). A Ponzi scheme is a trick that exist in the world of investments.
From the above explanation of both schemes it looks like they are similar but there is a difference between them.
DIFFERENCE BETWEEN A PONZI SCHEME AND A PYRAMID SCHEME
With a Ponzi scheme, the participants believe that they are earning returns or profits from their investment meanwhile in reality there is nothing that they have invested in. However, in a pyramid scheme, the participants are aware that they earn money by products traded for them and by finding new people to join. So with the pyramid scheme the participants themselves becomes part of the scheme. They are usually referred to by the term “songbirds”. Songbirds are the participants who preach the business (the pyramid scheme) to either their friends, families, relatives, coworkers, employers, employees etc.
HOW PONZI SCHEMES WORK.
This are quoted words from Tamar Frankel, a Professor of Law at Boston University. Whom is well known for his knowledge on Ponzi scheme.
“Ponzi schemes are simple. A con artist (trickster) offers obligation that promise very high returns at seemingly very low risk from a business that does not in fact exist or a secrete idea that does not work out. The con artist helps himself to the investors’ money and pays the promised high returns to earlier investors from the money handed over by these and later investors. The scheme ends when there is no more money from new investors.” (Frankel, 2009, p. 2).
Those who initiate the scheme benefit from the profit that can be derived from the operation. Not every investor loses from a Ponzi scheme. Usually, those people who joined first are paid with the monies of later investors. So if these earlier investors quits along the way, then it means that they have lose nothing and they are the lucky ones. But the later investors will always be the ones to suffer. So one thing that must be noted about this scheme is that the schemers offer very higher returns with lower risk. And this is what attract people the most.
THE MOST POPULAR PONZI SCHEMES
There are no books or articles that talks about Ponzi schemes and would not refer to the names of Charles Ponzi and Bernard Madoff.
Ponzi scheme is named after Charles Ponzi. He is an Italian who settled in the United States. In the 1920s Charles Ponzi tricked thousands of people into investing in a postage stamp scheme. At the time that he brought up the scheme the annual interest rate for saving in a bank was 5%. But Charles Ponzi promised to pay investors 50% on their investment within 45 days and a 100% within 90 days by buying discounted postal reply coupons in other countries and redeeming them at face value in the U.S as a form of arbitrage. However, there were no real investments. He used the incoming funds to pay the earlier investors. And Ponzi was consistent in the payment when the days are due, this convinced a lot of people to invest with him. But when Ponzi was caught, the scheme collapsed and this cost investors $20 million at the time. So the term Ponzi scheme was named after Charles Ponzi because the scheme became so identified with him.
HOW TO IDENTIFY A PONZI SCHEME.
Now I hope you have a general knowledge on Ponzi schemes and how they are operated. My aim is that you don’t fall victim of such schemes. For that matter, let consider the following red flags to avoid been victims.
1. Abnormally High Returns with Low Risk.
The common sign to identify a Ponzi scheme in any investment is the promise of giving higher returns that would be difficult to come in any investment. For example looking at Charles Ponzi’s scheme he offered to give 50% returns within 45 days and this is abnormal because even at the time banks were offering an annual rate of 5% on a bank account. There is an old adage that “when it looks too good to be true, then is probably is”.
2. No clear Business Model
Before you invest in a business make sure that you understand how the business operate and how profits are generated. If the business model cannot be explained to you in simple terms then just know that that business is not worth investing. Fraudsters and tricksters usually employ complicated ways to explain how their business model works to confuse you (investor). The bottom line is that if you can’t understand the business model then stay away.
3. Guaranteed Returns
In every investment there is some level of risk associated. However, these fraudsters and schemers because they want people to join their scheme they will assure people of great returns which trigger investors greed and them believe at all cost. So you have to be very suspicious of people who offer you an investment opportunity with guaranteed returns.
4. The Need for A Chain of Investors
For a Ponzi scheme to keep on going then new investors must be joining all the time. This is because without the stream of new investors, the schemers or fraudsters will not be able to pay the previous investors and the scheme will collapse. So if you are offered an investment opportunity and as part of your mandate, you are pressured to find new investors or you are rewarded for bring new investors on board. Then the danger alarm should be ringing.
5. The Pressure to Act Now
This is also a key feature of fraudsters and schemers. They try to create a false sense of urgency by making the investing believe that the opportunity is available only for limited time. Every legit investment will not pressure you to invest because you need time to make decisions. So if you see anything like this, you should know where you are heading to.
6. The Pressure to Reinvest or Plough back Returns
The fraudsters usually pressure investors to reinvest their returns for more. They do just because they need money to pay the other investors. But the trick is that, they pay those earlier investors so that people will believe in the business. They now pressure them to reinvest and the money will just be circulating for the scheme to be in operation.
7. Credibility through associations.
The fraudsters try to lure as much people to be part of them as family and friends. So that this people will promote the business make cover up for them.
There may be a lot of red flags to help you identify a Ponzi scheme, but with the list above I hope you will be able to identify one when knock at your door.
Be careful when you want to invest! I leave you with this saying; “If it looks too good to be true then is probably is”.
I would be happy if you share your thought on this topic at the comment section.
All suggestions are welcomed. Thank you.
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