How Do Ponzi Scams Differ From Pyramid Schemes?

How Do Ponzi Scams Differ From Pyramid Schemes?
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This article on Ponzi scams is part five of a series on some of Wall Street’s biggest frauds and how to avoid them. Click here for part one on the “Wolf of Wall Street” and microcap stocks. For part two on pre-IPO scams click here. Click here for part three on precious metals fraud. Click here for part four on binary options fraud.  For part five on pyramid schemes click here.

The terms “Ponzi scheme” and “pyramid scheme” are often used interchangeably, but they aren’t exactly the same thing. Essentially, some Ponzi schemes can be pyramid schemes, but not all pyramid schemes are Ponzi schemes.

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Charles Ponzi

Ponzi scams are named for Charles Ponzi, who ran his scheme in the early 1900s. He first saw such a scheme while working as a bank teller and then manager at Banco Zarossi, a bank in Montreal. After he earned the role of manager, he discovered that the bank was in dire financial straits. It paid depositors 6% interest, which was twice the going rate at that time.

The result was rapid growth, and the bank ended up making some bad real estate loans, which put into financial distress. Banco Zarossi was paying the 6% interest to depositors using money deposited in newer accounts instead of money earned as a profit on investments. Such schemes are not sustainable, and as a result, the bank ended up failing, and Zarossi himself ran away to Mexico with most of the bank’s money.

After a series of financial misadventures, Ponzi started the Securities Exchange Company and started promoting his scheme, which involved purchasing discounted postal reply coupons in other countries and them redeeming them in the U.S. at face value to turn a profit. As a form of arbitrage, this business in and of itself was not illegal. However, he did promise those who bought into his scheme that they would make a 50% profit in only 45 days or 100% profit within 90 days.

Ponzi Scams: A Look At The First One

Instead of buying postal reply coupons as he said he would, he recruited new investors and used their money to pay earlier investors. The more previous investors were paid, the more new investors became interested in the scheme. By July 1920, Ponzi was bringing in $1 million weekly. And by the end of the money, he was nearing $1 million daily. Many of his investors mortgaged their homes and emptied their life savings to invest in his scheme. Most of them reinvested their profits rather than taking them.

The big problem with Ponzi’s scheme was that it was impossible to change the postal replay coupons into cash due to the large volumes of cash he was handling. Thus, he kept paying older investors using funds from new investors, and that is the hallmark of the Ponzi scheme.

Pyramid schemes and Ponzi schemes share some similarities. In both cases, funds received from new investors are used to pay previous investors. Victims believe their investment is paying off, but in reality it’s being supported through recruitment rather than actual investments. The key difference between the two types of scheme is that pyramid schemes involve recruiting new members to supposedly sell products, although products aren’t actually the focus. Victims of Ponzi schemes, on the other hand, believe their investments are earning them money when they actually aren’t.

How to spot Ponzi Scams

The Securities and Exchange Commission has written extensively about Ponzi schemes. According to the SEC, a major red flag that a plan might actually be a Ponzi scheme is the promise of high returns with little or no risk. Investors should always be aware that every investment carries some amount of risk. Additionally, no investment can ever offer “guaranteed” returns. In most cases, the higher the potential return, the more risk is involved.

Another warning sign is returns that are too consistently the same. Prices of investments always fluctuate, so if the returns are steady and upward, regardless of what the rest of the market is doing, investors should beware.

Ponzi scams are also usually not registered with the SEC or state regulators, so whenever you are considering making an investment, you should check to make sure it is registered. In addition to ensuring that the investment is legal, registration also provides more information for investors to learn about the company, its management, finances, and products and services. In addition to the investment itself being registered, the seller must also be registered. Most perpetrators of Ponzi schemes are not licensed to sell investments.

The SEC also advises investors to avoid investment strategies that are secretive or overly complex and to invest only in what they understand. Lack of information is a major red flag.

Another sign of a potential Ponzi scheme is if you have trouble receiving payments or cashing out your investments.

This article first appeared on ValueWalk Premium

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