Many people have heard of both a ponzi scheme and a pyramid scheme but not many people understand the differences between the two.
Both sound equally as illegal and unethical. Both are schemes designed to deceive the average investor. Both tend to have shorter than longer lives, and are usually ways to make a quick illegal dollar at the expense of the investors who get into the game late. So what exactly is a ponzi scheme and a pyramid scheme and what are the differences between the two?
Of all ponzi schemes, the Bernie Madoff ponzi scheme was the most notorious because it was the largest and involved the most amount of money. Bernie Madoff ran a market making company in the late 20th century and was convicted in 2008 after his sons revealed that their dad had been operating a ponzi scheme for decades. Madoff's ponzi scheme is far too complex to dive into in this brief article. If you are interested in learning about the Madoff ponzi scheme, read the below and then check out wikipedia. But, for purposes of simplification and understanding, we will discuss the basic components of a ponzi scheme.
A ponzi scheme is an fraudulent investment scheme whereby a purported company makes money by paying old investors a return with the money of new investors. The company never makes a profit, they simply take from Peter and give to Paul. They lure investors by telling investors the company is in the business of X (say, flipping houses) and that the investor can get a nice return on their money. The investor, we'll call him Bob, listens to this sales pitch and says, "Ah, 5% return, that sounds great! Here is a $100,000". The company then takes that money, keeps a fraction for itself, and then pays out all the guys who invested before Bob. In time the process becomes unsustainable, as it becomes difficult to continuously raise money, keep track of obligations, and dodge the long arm of the law. There are far too many avenues of exposure.
A pyramid scheme is similar to a ponzi scheme in that it recruits investors by peddling the illusion of sustainable assets and returns. It is different in a few respects:
1. Whereas a ponzi scheme operates with a "central" company that does all the work. They recruit and pay out proceeds. In contrast, a pyramid scheme operates without centrality by getting investors to do the work themselves. You make money in a pyramid scheme not by sitting back and waiting for a return, but by recruiting more people to join in the investment.
2. Unlike a ponzi scheme, a pyramid doesnt claim to have some extravagant formula for making money. The language is much simpler. The pyramid scheme explicitly tells you you'll have to put in work to make money.
3. A pyramid has a shorter life because it requires exponentially more investors that a ponzi scheme. Ponzi schemers can easily persuade you to reinvest your money, where as for each initial investor in a pyramid scheme and additional investor is needed to keep the scheme running.
The important thing to know about these is that it takes a prudent investor to not get swindled into investing in one of these things. Ostensibly, each investment will sound legitimate. The investor must remember that if a thing sounds too good to be true, then it probably is too good to be true.
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