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Ponzi Scheme or Pyramid Scheme - What's The Difference?

Written by: Hamish Hayward

Article Overview: What's the difference between a Ponzi scheme and a pyramid scheme? Does it matter?

Ponzi Scheme or Pyramid Scheme - What's The Difference?

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

They have no real product, the only real money being used is the entry fee. Be careful, some pyramid schemes will have very tenuous "products" which cannot really be sold to anyone who isn't participating in the scheme. That's why, when you are considering any investment, online or offline, a good product is one of the key criteria you should look for.

Let's have a look at Charles Ponzi's famous pyramid scheme. It's a perfect illustration of what you should avoid.

The 1920's Ponzi Scheme:
Carlo (Charles) Ponzi was born in Italy in 1882 and emigrated to the United States in 1903. After travelling around the country for 14 years, during which time he held a variety of jobs, Ponzi settled in Boston in 1917.

Two years later, in 1919, whilst performing research into a business venture which would involve publishing a magazine, Ponzi entered into 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. However, when Ponzi exchanged it at his local 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 planned to buy them in foreign countries, exchange them in the USA and make large profits in the process. Not such a bad idea really - you can see how Ponzi might have hoped to profit using this method.

Unfortunately, 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 - although it can't be confirmed with 100% certainty - that over 10,000 people paid out in excess of $9.8 million over an 8 month period. Ponzi used the money coming in from later investors to pay off those who had invested earlier. Simply put, he robbed Peter to pay Paul.

Inevitably, as the scheme grew, there just 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:
Today 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 will easilyavoid being caught up in one of these illegal schemes.

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