Why Are Pyramid Schemes A Scam?

Are pyramid schemes a way of making money?

At one point or another you were approached by someone, a very good salesmen, who had convinced you that there was an incredibly easy way to make money in which you would reap all of the benefits. All you would need to do is pay a few dollars and get a few other people to pay you the same few dollars. They would go on to the same, and by this point all your sceptical senses were tingling. If it sounded too good to be true, is it possible that it was a pyramid scheme?

I’m often asked for a “practical” use of skepticism and critical thought. Well, here’s a great example where skepticism can save you money and time. Pyramid schemes are a scam, plain and simple. Worried that your investment opportunity is a pyramid scheme? Read on, my friend.

What is a pyramid scheme?

There are two kinds of pyramid schemes: naked, and product based. A pyramid scheme works well for only a very small number of people at the top of the pyramid. The main characteristic of a pyramid scheme is that is that people only make money by recruiting other members. The number of people involved in the scheme grows geometrically, so that the base of the pyramid becomes very wide, very quickly.

In a naked pyramid scheme, there isn’t even a product. The formula for “success” is as follows:

• One person recruits 6 other people to participate in the “wonderful opportunity”
• The 6 new recruits each pay the recruiter $100
• The recruiter now tells them to recruit 6 more people and do the same
• So if each recruit gets someone new, they will each end up with $500 from a very cool $100 investment.

So what’s the problem? Pyramid schemes become unsustainable very quickly.

For example, assume the 6 new recruits each find 6 more people to make their $500. Now these newer recruits will need to find 216 people so they can each make their $500. Assume again, for the sake of argument, that these 216 newest recruits are successful. They have to find 1,296 people just so they can each make their $500.  At this point, you’re at the size of a small town, and at the next level, 7,776 people are needed. Pretty quickly, you run out of people to find as new recruits, and the pyramid collapses since everyone at the bottom has lost their investment… By level 11, you require just about every person in the United States to become a recruit, and by level 13, you’ve exceeded the Earth’s population! The larger the initial group of people, the less levels needed until the pyramid collapses.

In a product based pyramid scheme, it’s the same idea, except that it’s masked as a “sales” opportunity, usually of a bogus product:

• A distributor recruits 6 salespeople who each pay $100 for a starter kit of products to sell.
• The distributor gets 10 percent of each starter kit that’s sold.
• The distributor also gets a cut of 10 percent of each product that any of the recruits sell (including additional starter kits).
• The recruits are told that the fastest way to make money isn’t by selling products, but by recruiting more people to buy starter kits (sound familiar yet?)
• The people at the top of the pyramid get commissions from everyone in their downline (the people below them in the pyramid).

Usually, the products have such a low margin, that it’s nearly impossible to make a profit without getting more recruits… and we we know what happens then. By the time you’re at the 12^th level of the pyramid, you need to recruit 2 billion people so that everyone can make back their money. At the ninth level, you’d need 13 billion people… which is almost twice the population of the Earth.

Now, take a light break before we get into the mathematical proof…

Michael Scott from The Office gets himself into a pyramid scheme, and, as usual, hilarity ensues:

The folks over a FraudSquad have made a short video to help explain pyramid schemes:
http://www.youtube.com/watch?v=WNsIk4a0DJk

Mathematical Proof that Pyramid Schemes Are A Scam

For simplicity, assume there is one person on top of the pyramid and this person asks for a fixed amount of money, say $1, to a second person, with the promise that if he convinces two more people to join and pay the entrance fee of $1, he will get $2 which would double up the initial investment.

At this point the first two people have made $1 dollar each. The other two people have to recruit two people each in order to double up their money. Now, we’re at the fourth level of the pyramid, where 1+1+2+4=8 people are involved in the scheme.

As the pyramid grows and more levels are added, the number of people involved increases geometrically, so that at level n there will be 1+1+2+…+2^n-2 persons in the scheme, and the bottom 2^n-2 have to recruit 2^n-1 new people in order to receive money. For example, when n = 34 (ie, there are 34 levels in the pyramid), the number of people invovled is 2^34-1 or 8,589,934,592 people, which again, is larger than the population on Earth (I chose n = 34 levels to illustrate that point).

This is what makes the scheme fraudulent: since the amount of people involved increases geometrically, the pyramid collapses because there are no more people to recruit and the people at the bottom of the pyramid all lose their initial “investment”.

This table shows how many new paying members must be recruited at each level for programs (schemes) that require each new member to recruit 4, 5, 6, 7, or 8 new members. (data courtesy http://www.consumerfraudreporting.org/MLM_pyramid.php ).  Red cells indicate the times when it’s literally impossible for the scheme to work, as too many people are involved.  Orange indicates the instances where it’s theoretically possible, but realistically impossible (since no organizations exist with that kind of magnitude.  Yellow cells indicate that it’s possible, but you’d have to be an incredible salesperson to succeed… and be part of a large international organization…

Pyramid Scheme Statistics:

• 88 percent of the members will be on the bottom level of most pyramid schemes will lose their investment.
• In a naked (productless) pyramid scheme, 90.4 percent of people lose their investment.
• In product-based pyramid schemes, 99.88 percent lose their investment.

What About Multi-Level Marketing Schemes?

Multi-level marketing (MLM) is similar to pyramid schemes in that, to be successful, you have to recruit new members from your network and form a downline. In MLMs, you earn money in two ways: by selling a product, and/or by receiving commissions from the sales of your downline. MLMs, although subject to constant debate, are legal, however, pyramid schemes are not. An example of a popular MLM is Amway Corp.

Even though MLMs are legal, they still provide a terribly low income for most people. Several sources have commented on the income level of specific MLMs or MLMs in general:

• The Times: “The Government investigation claims to have revealed that just 10 per cent of Amway’s agents in Britain make any profit, with less than one in ten selling a single item of the group’s products.
• Scheibeler, a high level “Emerald” Amway member: “UK Justice Norris found in 2008 that out of an IBO [Independent Business Owners] population of 33,000, ‘only about 90 made sufficient incomes to cover the costs of actively building their business.’ That’s a 99.7 percent loss rate for investors.”
• Newsweek: based on Mona Vie’s own 2007 income disclosure statement “fewer than 1 percent qualified for commissions and of those, only 10 percent made more than $100 a week.”
• Business Students Focus on Ethics: “In the USA, the average annual income from MLM for 90% MLM members is no more than US $5,000, which is far from being a sufficient means of making a living (San Lian Life Weekly 1998)”
• USA Today: “While earning potential varies by company and sales ability, DSA says the median annual income for those in direct sales is $2,400.”In an October 15, 2010 article, it was stated that documents of a MLM called Fortune reveal that 30 percent of its representatives make no money and that 54 percent of the remaining 70 percent only make $93 a month.

How To Avoid Being Sucked Into A Pyramid Scheme:

• Be skeptical, be careful, don’t let a sales pitch get you so excited that you can’t even think straight.
• Get an unbiased opinion from a family member or friend before jumping in.
• Research the “investment opportunity”, make sure the company is legitimate.  Verify the claims – check the organizations track record.
• Make sure you fully understand the business strategy. Don’t jump in because it sounds too good to be true, because it probably is too good to be true.

The Ironic Conclusion

Pyramid schemes are a scam, plain and simple. Multi-level marketing schemes are barely legal, and offer very little return for their required investment of cash and time.

So, did you find this article helped to improve your understanding of pyramid schemes? If so, do your friends and family a favor by sharing this information with at least ten of them. Then ask each of them to share it with ten more people, and suggest they tell each of them to share it with ten more, and . . . .