Ponzi Scheme vs Pyramid Scheme: What's the Difference

Did you know that Bernie Madoff stole $20 billion dollars before he was caught? How did he do it? Well, people gave it to him. Madoff was the leader of an elaborate Ponzi scheme that allowed him to take people’s life savings and destroy them for his gain. Unfortunately, most of the people who gave Madoff money have still not received it back. Many of these people who fell for his scheme were intelligent people, but that doesn’t mean they weren’t susceptible to his lies. As an investor yourself, there’s a chance you could even fall for one of these schemes. But before you can identify a scheme, you need to know the different types. Madoff’s had a Ponzi scheme, but there are also pyramid schemes. Don’t know Ponzi scheme vs pyramid scheme? Lucky for you, this article will tell you everything you need to know. Read on to learn more!

Let’s Define Them

Before we can discuss the differences between Ponzi schemes and pyramid schemes, we have to understand what they both are. Let’s define them. First up, Ponzi schemes.

Ponzi Schemes: Defined

Ponzi schemes, in short, are when a Ponzi scheme leader uses money from new investors to pay old ones. For example, let’s say Olivia decides to run a Ponzi scheme. She asks her friend Cooper to invest with her; he invests $1,000, and Olivia promises a 10% annual return on investment. After a year, Cooper wants his investment back. (Keep in mind that the investment should be $1,100). The problem is that Olivia isn’t good at running a Ponzi scheme and hasn’t found any other investors yet. Quickly, Olivia dupes her other friend Annie to give her 1,000 with a 10% annual return on investment. Now Olivia can give Alex the money he deserves, and she’s made $900 off of her friend Annie! The problem is that, eventually, Olivia will run out of money unless she can dupe more friends. This is often how Ponzi schemes are caught. If too many people pull out of the scheme at one time, the leader won’t have the funds to pay them. Here are some common red flags for Ponzi schemes:

You can’t have access to your money. This means that the person running the Ponzi scheme is often looking for new investors to give you money back.
Your investments make too much money. If you’re always having a great return rate, there’s a chance it’s a Ponzi scheme. Investments won’t always pan out.
There’s no risk. You can’t make money on an investment with no risk. If your broker uses the word “guarantee,” you should consider finding a different broker.
It’s too complex. If your broker can’t explain what they’re doing with your money, that’s a really bad sign. Investing can be complicated, but a professional should be able to explain it to anyone.

Name Origins

A Ponzi scheme gets its name from Charles Ponzi. In the early 20th century, Ponzi tricked thousands of people into investing their money in stamps. At the beginning of his scheme, he actually bought stamps, but because he promised a 50 percent return rate, he wasn’t able to keep up. Instead, he started using money from other investors to pay others. Ponzi wasn’t the first to do something like this, but his situation became so famous that it’s why we have the name today.

Pyramid Scheme: Defined

Pyramid schemes are often easier to spot because you practically know when you’re joining one. As someone in a pyramid scheme, you sell a product or the idea of a product to other people. But you have to pay a certain amount of money to get the product or to join the pyramid scheme. This means that the only way you can make money is by getting others to join the pyramid scheme or by selling the product. Pyramid schemes are technically not illegal because the investors have to know the situation up front. In fact, some investors can make money in the long term. Here are some common red flags for pyramid schemes:

You have to pay something before you can invest. Any money you put into a company should be invested. If there’s something like a “flat fee” before you can invest, get out.
You have to sell something. An investment shouldn’t mean you have to spend money. That’s working for free!
You make more money if friends sign up. This is an effective way to get more people in a pyramid scheme. If you make more money if people sign up, it’s a pyramid scheme.

Sales vs a Pyramid Scheme

Pyramid schemes sound quite similar to a regular sales job, but they are far from it. A pyramid scheme will ask you to buy the products before you can sell them. A sales job will give you the products to sell. Keep in mind that many pyramid schemes will disguise themselves as businesses.

Comparison

After looking at these two schemes, it’s easy to see why people can lose thousands in these schemes. It’s also easy to see why people need to be careful when choosing an investment. But what’s the main difference? The main difference between a Ponzi scheme and pyramid scheme is that the people in a pyramid scheme know they are in a pyramid scheme. In a Ponzi scheme, participants do not know. That being said, you can still be tricked into a Pyramid scheme if you’re not careful. Be sure to look out for the common red flags mentioned earlier.