Everyday Financial Guide

January 9, 2012

How Pyramid Schemes Work

Filed under: Investing — Tags: , , , , , , , — thefranksteak @ 1:12 pm

The truth is that pyramid schemes never actually work. A few people make some money from such a scam but most suckers lose every cent they invest. The reason such enterprises cannot work is that their success is mathematically impossible.

The Pyramid Scheme Explained

A pyramid scheme or Ponzi scheme is any sort of fraud in which a con artist uses money collected from later investors to pay off earlier investors.

A typical scheme works like this: Joe Sleaze sells the suckers in Dumbville several hundred shares of worthless stock. Next Joe travels to Suckertown where he sells several hundred more shares of worthless stock. Mr. Sleaze then pays the suckers in Dumbville with the money he collected from their brethren in Suckertown.

That way it looks like the worthless investment is making money when all that is really going on is that Joe is selling shares. It turns the earlier investors into marketers for the con game because they tell everybody about the “profit” they made on the investment.

The problem is that sooner or later Joe is going to run out of suckers. When he cannot sell any more shares the pyramid stops making money and collapses.

Pyramid Schemes Can Take Many Forms

Even though all pyramid schemes operate in much the same way they can take many forms. Con artists love the pyramid because they can use it to sell almost anything and finance the scam with the suckers’ money.

Many investment scams, particularly those that involve derivatives or accounts receivable loans are pyramid schemes. Other common variations include offshore investments, hedge-futures trading and high-yield investments. Bernie Madoff’s investment scam was a pyramid because he was paying investors off with other investors’ money. Many network and multi level marketing businesses are actually pyramid schemes.

Quite a few scams perpetuated by shady investment advisors are also pyramids. Even securities dealers working for major national brokerages have been caught running pyramid schemes. In 2004 the SEC fined Raymond James $6.9 million because one of its brokers, Dennis Herula was involved in a scheme.

Math dooms the Pyramid

The one thing all of these frauds have in common is that they cannot work. A simple mathematical analysis proves they will collapse.

Math shows that a simple multilevel marketing con that required each marketer to recruit four new suckers would run out of suckers in just 12 levels. If the marketer recruited four victims each of them would have to recruit four victims. That would be 64 marketers. If they kept it up for 12 levels the marketers would have to recruit 13.8 billion people to sustain the racket. Since there are only 7 billion people in the world it’s obvious this cannot work.

Every other pyramid scheme is doomed by similar numbers. The only way the con could be sustained would be with an endless supply of suckers.

Why People Fall for Pyramid Schemes

The main reason people fall for a pyramid scheme is that they refuse to investigate what they are investing in. Fraudsters count on the fact that a lot of people look only at the fast money and fail to ask how the scheme works.

Most victims could avoid being taken if they simply asked what was going on. Quite a few people fall for such scams perpetuated by people they trust. They see a friend or relative making money and decide to cash in. If somebody recommends an investment check it and the person or organization behind it out carefully. An easy to perform such an investigation is to run an internet search on the investment and those behind it. If there are complaints, criminal charges or lawsuits the search will probably turn them up.

Always be leery of investments sold through informal or nontraditional channels such as social contacts and anything that promises big returns or fast returns. If you cannot figure out how something is going to make money refuse to invest in it. If you see somebody else making money from something you believe to be impossible chances are it is a pyramid scam.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Annuities Explained, Fixed Income Annuity, and Annuity Leads.

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