The difference between pyramid schemes and Ponzi schemes is in the methodology. Pyramid schemes rely on multiple levels of investors, each promising exorbitant returns to the succeeding level, whereas Ponzi schemes feature a central figure who promises exorbitant returns to all investors.
Knowing risk as they do, those at BusinessInsurance.org want to help you recognize and steer clear of these dangerous investments:
Pyramid schemes are organized into investor levels. At each level, investors are responsible for recruiting new investors and obtaining money from them. It begins when one person asks a small group of people for a sum of money in exchange for a promise of large returns. Each of those investors must then approach another small group of investors and make the same promises. After recruiting new investors, existing investors pay a portion of the new investments to the level above them and keep the rest. If an investor does not recruit additional investors, they receive no return on their original investment, so the financial incentive lies in recruiting new investors.
Pyramid schemes collapse when the bottom level cannot recruit enough willing investors to sustain the flow of money to the top of the pyramid.
Ponzi schemes are similar, except that participants don't have to recruit others. Rather, they invest passively in exchange for a promised return on their investment. Ponzi schemes are named after Charles Ponzi, who infamously defrauded willing investors out of $6 million by exploiting international price differences in a postal product. He promised investors he could help them make money the same way. After doling out some of the initial returns, Ponzi began embezzling the rest and eventually walked off with the money. He was caught a short time later, and because the fraud was such a huge sum of money for the time, his special brand of scheme soon bore his name.
Ponzi schemes collapse when investors panic and attempt to reclaim their money. Though with the false promise of high returns from novel investments, Ponzi schemes often attract more seasoned investors.
Want to learn more about the schemes and how to spot them? Read the Federal Trade Commission Attorney General Debra Valentine's speech, Pyramid Schemes.