What is a pyramid scheme?
Pyramid schemes are a type of financial scam that promises high returns to investors, but only the initial investors make money. Later investors typically lose their investment. Here’s how they work and how to avoid them.
How does a pyramid scheme work?
Pyramid schemes get their name from the distribution of earnings that take place between their members. Most of the funds in the scheme go to the initial investors at the top, while subsequent investors end up funding the scheme, eventually getting little or nothing out of it.
Instead of investing their members’ funds responsibly or providing them with products that really sell, pyramid schemes simply take the initial signup fees paid by new members, pay them a few good investment returns or sales commissions to keep them happy, and then move on to the next member.
- The initial fees paid by new members are used to pay commissions to existing members, with members who refer newcomers receiving commissions on the fees they pay.
- This continues all the way down the chain of referrals, with the original members taking a commission on every member who joined after them.
- You could say that pyramid schemes operate on a “rob Peter to pay Paul” model, because the only source of income the scheme has is initial fees paid by new members.
The fraudulent side of pyramid schemes is that you’ll never know this is the case: the scheme will always claim to generate its income from investments or product sales.
Eventually, the income from new members runs out or is insufficient to pay commissions to other members and the scheme collapses. At this stage, every member loses the money they invested in the scheme and the founders, if arrested, face criminal charges.
4 different types of pyramid schemes:
Pyramid schemes come in different varieties, but they all operate in roughly the same manner. The most common types of pyramid schemes perpetrated by scammers are discussed in more detail below.
If you are curious about investing in Forex, read more in “Is forex a pyramid scheme?“
1. Multi-Level Marketing Pyramid Scheme
Multi-level marketing (MLM) businesses are legal if they sell real products or services. Pyramid schemes, on the other hand, are fraudulent because they derive all their income from signup fees.
If you receive an invitation to join an MLM company that offers large financial rewards but low-quality products, it’s a red flag. These schemes emphasize recruitment over sales, and some may not even bother to send you anything to sell.
If you’re simply recruiting new members to take a commission from their signup fees, you’ve been lured into a pyramid scheme. It’s best to avoid these types of schemes altogether.
2. Chain Emails
A primitive but tricky type of pyramid scheme is the chain email and you may have been the unwitting recipient of these messages in the past.
- This type of scheme started out as chain letters and they have been around for centuries.
- The email will promise you a large sum of money if you remove the name at the top of the chain, replace it with your name and send it to a certain number of people.
You’ll also be asked to send a small amount of money (typically $10 or less) to the person who sent it to you.
While chain emails may sound silly or as easy to detect as scams, a surprising number of people are taken in by them. Typically, after paying the person who sent you the letter, you’ll send it on to a number of people and receive nothing from them. After all, they’re free to delete it and never send you a cent.
As with all the pyramid schemes on the list, it’s best to simply ignore chain emails and move along.
3. Ponzi Schemes
Ponzi schemes are fraudulent investment schemes that promise high returns to investors. They work by using money from new investors to pay off old investors, creating the illusion of success.
Ponzi schemes can be very convincing, and even financial experts have been taken in. The best way to avoid them is to work with reputable brokers and banks that issue regular audit reports.
Unlicensed brokers, small firms with a fly-by-night attitude, and brokers who sell their investment products door-to-door should be avoided.
4. Money Multiplier Schemes
Online pyramid schemes use social media to lure people in with promises of high returns. However, these schemes eventually collapse, and members who have already paid in lose their money.
- Online pyramid schemes are especially tricky because they often incentivize their members to post positive reviews on social media and review websites.
- This gives internet users the impression that the scheme is legitimate in its early stages.
- After a while, as members fail to receive their payouts, the scheme will gain an online reputation for being a scam – but it’s too late by then for members who have already paid in.
How to spot a pyramid scheme?
All pyramid schemes have several things in common that set them apart as scams. If you encounter a scheme that fits this description, you have every reason to be suspicious:
- It promises a large reward, unusually high returns on investment, or “easy money”.
- The focus is on recruiting new members instead of legitimate income generation.
- The company is unknown, unlicensed, and doesn’t have a physical address.
- You are not required to have any particular skills or knowledge in order to earn the large income promised by the scheme.
Overall, the age-old advice applies: if it’s too good to be true, it probably is. Pyramid schemes sound great on paper, but they are one of the fastest ways to lose money.
All pyramid schemes will collapse in the end
Pyramid schemes are scams that pay dividends or income at the beginning to lure in new members. They eventually collapse, and the more you have invested, the more you stand to lose.
To avoid becoming a victim, have reasonable expectations and stick to legitimate businesses, employers, and investment brokers. If you lost money in a pyramid scheme, contact a fund recovery specialist today.