First of all, a lot of "Get Rich Quick" ideas are founded on the premise of funding one investor's profits by luring in other investors. Any deals that do so without actually having an underlying product or investment that can make a profit can be characterized as a "Ponzi scheme" or a "Pyramid Scheme." Both of these are illegal. There are many other types of frauds and scams, but, the main thrust of the ideas behind these schemes is as follows:
1. In a Ponzi scheme, the investor is generally told about some obscure investment opportunity that has been making people rich. He or she now has an opportunity to get in on it. Often, the scammers target the latest fad, real estate flipping, e.g., and are very good salespeople. The problem is there is no underlying investment; rather, the only money made by the initial investors is other people's later investments. Sometimes, there is an ostensible underlying investment; however, the scammer only invests enough in such a vehicle to make the paperwork look good.
In reality, the person offering the investment is just spinning money from one person to another. The way the scheme works is that the scammer guarantees the investor a massive return on his/her investment: the original Charles Ponzi, for whom the scheme is named, told people he could double their money every 45 days. To do that, he needs to find enough investors to "double" the first investors' money. Let's say Investor A puts up $5,000.00. The scammer then gives him back his $5,000.00 plus $5,000.00 he or she gets from Investor B. The scam works until there are no more people from whom to get "investments." Then, it falls apart.
People do not have to be stupid or lower-class to fall for these schemes. The scammer, in fact, preys on many things including gaining the trust of the people he is ultimately defrauding. A lot of times, he ingratiates himself into the life of a community and gains some prominent members' trust. For example, he may join the local church to find victims. He then convinces authority figures within that church that he has a good investment idea. He gets to know the latest methods by which the news claims people are making money and claims to know how to get in on these investments. Maybe he will convince people that he can get in on the ground floor of the next IPO, credit derivatives or some other sexy sounding investment opportunity. Once there are a few investors on board, the person running the scam makes sure to show them results so they will recruit other investors.
Often the people who get in early do make money initially -- they is how the scam works. However, they are convinced, and convince themselves, that if they made so much money in such a short time, if they stay invested, they will continue to see even greater returns. They think that if they doubled their money in a month, their gains in a year are unimaginable. Thus, they never actually take their investment back or any of their returns. In fact, the scam depends on investors letting their investment returns ride and bringing in even more investors.
Some of the schemers are really smart: you get in on the deal and in a few weeks, you have lots of money in your bank account compared to what you invested. You think, oh my goodness, this is for real. You then promptly up the ante giving them back the money they returned to you on top of your original investment. And because you are not in the fraud business and you think you have stumbled on this unbelievable opportunity, you tell your friends and family.
The bigger the scam gets, the more likely it is to collapse: eventually, there are no new prospects to fuel gains for the older investors and they start to want their returns and money back. Some get it back; most of the time, the scammer puts it away where it cannot be touched. Once the fraud is disclosed, the person who started it all may be in trouble with the law, but, usually, the money they make is tied up and hidden and the investors do not see most of it back.
A recent example of such a scam was discussed in the New York Times. In The High Cost of Too Good To Be True, (November 27th), investors were lured into high-yield mortgage investments. Using Steve Garvey, the former baseball player as a spokesperson, a company called National Consumer Mortgage, bilked people out of tens of millions of dollars in one giant Ponzi scheme. NCM told investors that their money was being used to finance short-term loans to people who needed money quickly; hence, the yield was much higher than on traditional investment instruments. In reality, the man who ran the scam was using investments to show returns to earlier investors rather than using them to loan money. Besides showing bogus returns, he was also taking the money for his own gambling habit and to support his "lavish lifestyle." It was years before people caught on because he had enough new investors to show paper returns -- those investors thought they were doing so well, they were pitching it to other investors. He was himself becoming a prominent member of his community and the investment model made sense in today's society: high credit risk lending for mortgage instruments are supposed to yield higher than average returns.
When it all fell apart, many people lost a lot of hard-earned money -- not just the paper returns, but the underlying investments. Although the principal of the company has been indicted, the money is unlikely to be found. Not only did they lose actual dollars, they lost the opportunity to invest in legitimate investments. For some, this may set back their future financial plans indefinitely. For others, it will be a costly lesson but one from which they will recover.
I know that no one thinks it could happen to themselves, but, these people sounded like regular people who just were looking for a good way to invest their money. The returns were not so unusual as to raise the sort of red-flag that ought to be raised when anything too good to be true comes along. I could not really fault these people for getting involved in an investment with someone they had grown to trust. But it teaches us all a strong lesson: know where your money is going.
2. A pyramid scheme is actually different from a Ponzi scheme in that the investors know that to make money, they have to bring in others to buy the product or service that they are offering. For a pyramid scheme to work, the people to whom you sell must also become part of the distribution chain for the product or service.
The simplest pyramid scheme is a chain letter: -- you send in a dollar to the first person on a list, then cross off her name, put the next person's name first and your name on the bottom. You send the letter to ten people and the chain begins again. The theory is that by the time you are first on the list, your name is given to hundreds of thousands of people and money starts pouring in. Everyone involved knows what they are doing; what they do not know is that mathematically speaking, if everyone in the world got the letter, they would never be at the top of the list (I'm not exactly sure why, I am sure a smarter math person could figure it out). In any event, assuming you could make money from such a venture, it is illegal because there is absolutely no underlying service, product or investment. It is a pyramid pure and simple because there are a few people at the top, a few in the middle and way too many at the bottom propping up those at the top. Those at the bottom will not see results whereas those at the top could make untold amounts of money.
Most pyramid schemes, however, are far more sophisticated than a simple chain letter but no different really. A pyramid scheme is often called a multi-level marketing opportunity. Some multi-level marketing is legitimate, for example, Avon and Tupperware. A legitimate multi-level marketing business seems like a pyramid because one person sells a product and tries to recruit other sellers. When the person sells, the person recruiting him gets paid and when that person recruits someone else, his recruiter and all the rest of the people in the "up-line" also get paid for every single sale. Such a system works all the way up and down a line: so if A recruits B and B recruits C and C recruits D, sales made by D are credited to A, B & C as well as to D him or herself.
I do not endorse the whole concept of multi-level marketing for one simple reason: if the idea takes off, there seem to be far too many who need to get a commission; thus, the underlying product has to be worth a lot less than its sales price in order for those people to get a fair cut; if it is not, then, they cannot really make much money. Hence, it is either a bad approach for the consumer or for the sales force. The argument against this, to be fair, is that Multi-Level Marketing cuts out the enormous costs of advertising a product; hence, the product is not unfairly priced.
My other objection to multi-level marketing is that very few people succeed at it -- the statistics seem to indicate that less than 10% of such marketing salespersons actually stick with the program more than a year and less than that break even. They are generally required to buy a fair amount of sample products as well as training and marketing material; hence, there is a considerable investment before the person makes money. Moreover, unlike traditional sales forces, they have to create their own marketing opportunities, culling their prospects from friends, families, community organizations, social groups, etc. Hence, they look at every new person as a potential prospect and pull out their address books trying to convince others that their way is the best new idea out there.
Notwithstanding those objections, though, multi-level marketing is not necessarily a pyramid scheme and is permissible from a legal standpoint. The FTC did recently create some proposed rules requiring such organizations to disclose the success rate to potential recruits: these are rules that are vigorously opposed by the companies that do business in this method leaving me with a bit more distaste for their methods.
A true pyramid scheme, however, involves the sale of a product in which the price is completely out of line with its fair market value and the value of the "sale" is in fact the "opportunity" to make your own sales. Thus, it is a pyramid scheme because person A is not trying to sell a product at a decent price; instead, person A is selling mainly the opportunity to sell the opportunity to someone else. A large chain letter. The key difference between multi-level marketing and pyramid schemes is that in a multi-level marketing situation, a salesperson can actually make money off the sale of the product even if the buyer does not become a seller. If not, it is definitely a pyramid scheme and may be illegal.
Pyramid schemes are illegal for a reason: they involve fraud. The people who think they can make money, the people buying the products and the underlying nature of what is being bought and sold are all fraudulent. The people at the bottom cannot make a significant return on their investment, yet such people are absolutely essential for anyone to make money. It is a giant shift of wealth out of the bottom people's pockets into the pockets of those at the top. If the head of the pyramid said that, however, he would not make any money. So, to entice me to give him my money, he has to promise me that others will see what a great opportunity this is and buy into it as well -- fraud.
How can you protect yourself? There are so many promises of getting rich out there, how can you know if you are just being sold a place in the bottom of a pyramid or ponzi scheme or a real opportunity?
The short answer is that you cannot know for sure. Other than true scams, such as the National Consumer Mortgage scam, there are so many potential ways to "make" money on a "new" idea or product that people will need if only you convince them they need it. What about "no-money down" real estate investing. Some of that is a scam. In one scam, people with excellent credit put no money down to gain mortgages allegedly of great properties which were going to be bought and sold for a profit. Essentially, they thought they were lending their name and good credit standing in exchange for a significant percentage of the profit on the later sales of the land. What happened?
The head of the scam was using their names on mortgage documents for terrible properties and gaining mortgages. He then paid the people who signed the phony mortgage papers portions of the proceeds from the mortgages making them want to own more property under his management. They thought they were participating in the method the wealthy use to make money: buying into real estate. What they were doing were being used for the original scam artist to get a bunch of money in mortgages from banks on their names. Then, after he absconded with the money, the "investors" were left with higher mortgages than the value of the properties he bought.
Maybe these people in all of these schemes made an unforgivable mistake in putting their money into investments without really understanding what they were doing. I have been in the room with a great salesperson and I know full well the power that such a person can wield. I understand how someone might think that they have scrimped and saved and been diligent and now their scrimping and saving and diligence is going to pay off in better investment returns than the average investors. Plus, the American way is to take some risks. Those that do, however, are later labeled stupid.
As it turned out, these were scams -- pure and simple. But what about the other scams that are out there? Is a multi-level marketing plan an opportunity or a rip-off? Is a chance to make a greater than average return a risky but excellent investment or a rip-off?
You might be saying: "Who would be so stupid to fall for this stuff?" But, there are many reasons that people are drawn into such schemes. They see others making money and they want to also. The salespeople are good at their jobs. They are desperate or naive or vulnerable for some reason or another. They are not financially sophisticated. And, sometimes, maybe frequently, they are greedy. The way these scams are pitched, they just seem logical except for one thing: they seem too good to be true. Unfortunately, wealth cannot be made overnight. Someone can get lucky, yes, that is true. But no matter what, if someone offers you the opportunity to "get rich quick," don't even think about it: just say NO.