Pyramid Schemes and Ponzi Schemes

Pyramid schemes - also referred to as Ponzi schemes (after Charles Ponzi, who ran a very famous one in 1920) - are basically structured such that they use the entry fees from participants to make profits for earlier entrants to the scheme.

They have no real product, the only money being used is the entry fee. Be careful, some pyramid schemes have very tenuous “products” which cannot really be sold to anyone who isn’t participating in the scheme.

That’s why a good product is one of the key criteria when we evaluate businesses.

So let’s have a look at Charles Ponzi’s famous pyramid scheme. It’s a perfect illustration of what you should avoid.



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The 1920’s Ponzi Scheme

Carlo “Charles” Ponzi was born in Italy in 1882 and he emigrated to the United States in 1903. After travelling around the country for about 14 years, during which time he held a wide variety of jobs, Ponzi eventually settled in Boston in 1917.

In 1919, as part of his research into a business venture which would involve publishing a magazine, Ponzi was in correspondence with a business associate in Spain. At one point in their correspondence, Ponzi’s Spanish associate included an international postal reply coupon for Ponzi’s use. The coupon was included so that Ponzi could take it to a US post office and exchange it for postage stamps.

The coupon had been purchased in Spain for the equivalent of 1 cent - but when Ponzi exchanged it at the US post office he received 6 cents worth of postage stamps. Ponzi decided to set up a business to exploit the huge diffrence in the value of the international postal reply coupons. He would buy them in foreign countries, change them in the USA and make huge profits in the process.

Unfortunately for Ponzi, all the red tape, bureaucracy and the lengthy timeframes needed to transfer foreign currency at that time ate away at his profits and his scheme lost money. Undaunted, Ponzi registered his company at the end of December 1919 and promised his investors a 50% return on their money within 90 days. In fact, he claimed he could deliver a 50% return within 45 days - equivalent to doubling your money in 90 days.

In the first six months of 1920 thousands of people put money into Ponzi’s scheme. It’s estimated that over 10,000 people paid out over $9.8 million over an 8 month period in the end. Ponzi used the money coming in from later investors to pay off those who had invested earlier - he robbed Peter to pay Paul.

Inevitably, as the scheme grew, there simply weren’t enough people coming into the scheme to pay off the earlier investors. Ponzi was arrested in august 1920 and, after a lengthy examination of his books he was jailed for 5 years. A lot of people lost a lot of money.

The difference Between A Ponzi Scheme And A Pyramid Scheme

The terms Ponzi scheme and pyramid scheme are often used to mean the same thing. However, there is a slight difference.

A true Ponzi scheme usually promotes what appears to be a real investment opportunity which investors may contribute to without actually being an affiliate, distributor etc. A pyramid scheme, on the other hand, usually requires that participants make a payment for the right to recruit other people into the scheme, at which point they will receive money.

At the end of the day, this is splitting hairs a little. All you need to know is that people lose money in either of these schemes. Avoid them like the plague.

Evaluate your business opportunities in a logical manner - and pay particular attention to the product or range of products on offer - and you won’t get caught up in one of these illegal schemes.


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