Ponzi vs: Pyramid Scheme: What's the Difference?

Pyramid schemes and Ponzi schemes have many similar characteristics based around the same concept: unsuspecting individuals get fooled by unscrupulous investors who promise them extraordinary returns in exchange for their money. However, in contrast to a regular investment, these types of schemes can offer consistent "profits" only as long as the number of investors continues to increase. Once the number tapers off, so does the money.

Ponzi and pyramid schemes are self-sustaining as long as cash outflows can be matched by monetary inflows. The basic differences arise in the type of products that schemers offer their clients and the structure of the two ploys, but both can be devastating if broken down.

Ponzi schemes are based on fraudulent investment management services—basically, investors contribute money to the "portfolio manager" who promises them a high return, and then when those investors want their money back, they are paid out with the incoming funds contributed by later investors. The person organizing this type of fraud is in charge of controlling the entire operation; they merely transfer funds from one client to another and forgo any real investment activities.

The most famous Ponzi scheme in recent history—and the single largest fraud of investors in the United States—was orchestrated for more than a decade by Bernard Madoff, who defrauded investors in Bernard L. Madoff Investment Securities LLC. Madoff built a large network of investors that he raised cash from, pooling his almost 5,000 clients' money into an account he withdrew from. He never actually invested the money, and once the financial crisis of 2008 took hold, he could no longer sustain the fraud. The SEC values the total loss to investors to be around $65 billion. The controversy sparked a period in late 2008 that is known as Ponzi Mania, in which regulators and investment professionals were on the hunt for other Ponzi schemes.

A pyramid scheme, on the other hand, is structured so that the initial schemer must recruit other investors who will continue to recruit other investors, and those investors will then continue to recruit additional investors, and so on. Sometimes there will be an incentive that is presented as an investment opportunity, such as the right to sell a particular product. Each investor pays the person who recruited them for the chance to sell this item. The recipient must share the proceeds with those at the higher levels of the pyramid structure.

One key difference is that pyramid schemes are harder to prove than Ponzi schemes. They are also better protected because the legal teams behind corporations are much more powerful than those protecting an individual. One of the largest accused pyramid schemes was with the nutritional company Herbalife (HLF). Even though they were labeled as an illegal pyramid scheme and paid out more than $200 million in damages, their products still sell, and the stock price looks healthy.

In the same way that investors should be investigating companies whose stock they purchase, it is equally as important to investigate those who manage their money. It is helpful to call the Securities and Exchange Commission (SEC) to ask if there are open investigations into a money manager or prior instances of fraud.

If an investor is considering getting involved in what appears to be a pyramid scheme, it would be beneficial to use a lawyer or CPA to scour the documents for inconsistencies.

There are two additional important factors to consider: The only guilty party in the Ponzi and pyramid scheme is the originator of the corrupt business practice, not the participants (as long as they are unaware of the illegal business practices). Secondly, a pyramid scheme differs from a multi-level marketing campaign, which offers legitimate products.