Pyramid schemes are one of the commonest types of investment scam.
The basis of a pyramid scheme is that victims:
- pay to participate in the scheme and,
- are promised a reward for recruiting further "investors" into the scheme.
As with a Ponzi scheme, this means that early investors often make large profits. However as the scheme needs more and more "investors" to keep joining, it is inevitable that will eventually run out of people willing to join. The result is the that the promoter makes are large profit, people who join early also make profits, and those who join later lose their "investments".
Consider an example to see how it works:
The promoter of a pyramid scheme starts by recruiting a hundred people and charges each of them £100 to join. Each person joining is promised £500 for every 10 people they recruit into the scheme.
All of the first hundred then manage to recruit 10 new members each. At this point the promoter of the scheme has collected £110,000 in fees and paid out £5,000.
The 1,000 investors in the second wave also get 10 recruits each. The promoter has now collected £1,110,000 and paid out £55,000.
The 10,000 investors in the third wave recruit their 10,000, the 100,000 in the fourth wave recruit a million, and the million in the fifth wave recruit 10 million.
With 10 million people trying to recruit new members it becomes very hard to recruit more. The scheme ends here.
At this point the promoter has made £1.1bn and paid out £500m. 1.1m people have made a £400 profit each and £10m will have lost £100 each.
If the 10 million in the sixth wave manage to get some new recruits the promoter will get yet more money, but as few of them are likely to manage to get the 10 required to get the £500, the promoter is likely to pay out little of this extra money.
A lot of money has moved around, but the net result is that the promoter of the scheme gains and most of the "investors" lose. Investing in a pyramid scheme is very similar to gambling, with the promoter playing the part of the bookmaker.
Schemes are likely to be shut down by the authorities long before they get this big. There are cases of pyramid schemes getting big enough to threaten national economies, as in Albania in the 1990s.
Promoters of pyramid schemes are usually very good at disguising their nature. There is a good description of their sales tactics on Quantloos' introduction multi-level marketing scams page. One of the commonest tricks is to claim that a pyramid scheme is a "multi-level marketing" scheme. Another is to use a more complicated scheme than the simple pyramid described above and claim that it is therefore not a pyramid scheme. As a general rule:
- If you have to recruit people into the scheme to make a profit, it is definitely a pyramid scheme.
- If it is marketing scheme that involves recruiting people to sell goods at above normal market prices, it is almost certainly a pyramid scheme.
- If a substantial part of the income it promises comes from recruiting new people into the scheme, it is probably a pyramid scheme.
- If there are any rewards for recruiting people into the scheme, look at it in detail, and check with regulators (the FSA in the UK) if you are unsure.
The last step is always a precaution worth taking with any investment that looks suspicious or offers rewards that look to good to be true - there is nothing to be lost by checking.