Ponzi Schemes vs. Pyramid Schemes: What Are They and How Can You Protect Yourself?
Investing has become increasingly popular and increasingly accessible, with Millennials and Gen Z investing their money earlier and at higher rates than previous generations. But that doesn’t mean there aren’t any risks involved. Especially if you’re new to investing, it can be easy to get caught up in the idea of making additional income—and fall victim to fraudulent investments like Ponzi and pyramid schemes.
You’ve likely heard of Ponzi and pyramid schemes before, but do you really know what they are or how to prevent yourself from investing money in them? The best way to ensure you’re making smart, safe investments is to do your research. Knowing the definitions of Ponzi vs. pyramid schemes, and the red flags to watch out for, is a great place to start.
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Ponzi Schemes vs. Pyramid Schemes: Similarities and Differences
What Is a Ponzi Scheme?
A Ponzi scheme is a type of investment fraud that uses funds from new investors to pay off previous investors. Since these schemes can only function with a consistent cash flow, organizers typically claim that they can generate high returns for almost no risk in order to attract new investors. This also makes them susceptible to failure: once investors stop coming in (or when existing investors cash out), Ponzi schemes tend to collapse.
The money people invest in a Ponzi scheme is neither secure nor used how it’s claimed to be. You may lose your entire initial investment, and never see any returns.
What Is a Pyramid Scheme?
A pyramid scheme is similar to a Ponzi scheme in that it promises high returns on an initial investment. However, the biggest difference between Ponzi schemes vs. pyramid schemes is that the latter requires people to recruit additional investors—who will recruit other investors, who will recruit other investors—in order to “move up” the chain.
This type of scheme typically begins with selling goods, and then quickly transitions into a vicious cycle of recruitment. Pyramid schemes can affect a lot of people, impacting a large volume of savings and investments.
Who’s at Risk?
Ponzi and pyramid schemes can affect any number of individuals and communities. In July 2020, for example, a Berks County man was sentenced to 10 years in prison for soliciting $60 million from his Amish and Mennonite clients—one of the largest Ponzi schemes in Pennsylvania history. And later in the same year, a lawyer from Nazareth, Pa. was sentenced for his role in a $2.7 million scheme.
How to Protect Yourself
While Ponzi and pyramid schemes can take many forms, there are some key characteristics to watch out for. First and foremost, it’s common for organizers to promise high returns with little-to-no risk—which typically isn’t possible. Risk and reward are inversely related, meaning that higher returns are often made from larger, less secure investments. If these types of promises are being made, do some further investigating. You should also be wary of consistent returns, which also aren’t typical.
Protecting yourself from both Ponzi and pyramid schemes requires looking out for a few red flags. If you have to recruit other investors, make a large upfront investment in order to participate, or are promised you’ll “get rich quick,” you’ll want to search for an alternative investment.
The key to avoiding financial schemes? Know the warning signs, stay informed, and be cautious about where you put your money.
A Smarter Way to Invest
Instead of chasing high returns, consider low-risk investments. Money market accounts, high yield savings accounts, savings bonds, and certificates of deposit are safer options that have guaranteed rates of return. Not only that, but these types of investments don’t put you at risk of losing your initial capital.