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Every once in a while, we hear about funds that offer very high returns, but which later fall from grace and which fail to pay investors anything. In Poland, the most famous case was Amber Gold, and in the United States the most famous case was the Bernie Madoff Affair, swindling investors for sixty-four million dollars. In spite of this, we still hear about pyramid schemes collapsing like houses of cards from time to time, mainly because there are still those who willingly become engorged by the lure of such organisations. Indeed, greed without forethought is more conniving and quicker at the helm than other humanly desires, and ultimately may compel some individuals to put their money in pyramid schemes.
What exactly is a pyramid scheme?
A pyramid scheme is an institution that promises high returns from investment. The only problem with this is that the institutions do not actually invest our money. Rather, the money of “clients” is given to support the luxurious lifestyles of those who manage the institution. All return on investment exists solely and exclusively on paper. The sort of pyramid scheme that existed for many years in the Bernie Madoff affair was allowed to have a place in the world on the condition that the number of people investing in the fund did not surpass the number of people who demand their returns on investment. The return on assets for people taking out their capital from the fund is made possible by the money of people who are coming into the fold. However, this is only a matter of time. When investors become frightened by market fluctuations, or other events transpire that cause a loss from investment, those who partake in the scheme begin to take out their financial assets, which results in the death of the pyramid scheme. Because the pyramid is not able to hide the outflows of our assets with new inflows from new investors, this becomes the moment when we need to acknowledge our money as forever forgone and lost.
The average lifespan of a pyramid scheme is around six to eight years, even though the Bernie Madoff scheme existed for twenty years. The reputation of the person (Bernie Madoff used to be the Chairman of the American electronic exchange, NASDAQ), as well as the luxurious building on Wall Street (called the Lipstick Building) built trust, which allowed him to sustain the scheme for around twenty years. This is rare, however.
Whilst conducting a lecture touching upon the workings of pyramid schemes many pupils could not believe that the returns from investment, visible through the billings of the scheme, did not really exist. Indeed, a pyramid scheme from the onset does not invest the financial assets of its clients. They write them artificial interest rates, or returns on investment, but it is necessary to understand that physically they do not conduct any investment and we do not obtain any financial products. Everything merely appears on paper and the billings are falsified. Of course, however, this does not mean that investors do not retain anything. After time, when new people bring their money into the pyramid, our returns are paid in accordance with what is shown on paper. But when others stop to invest in the pyramid we have to consider our savings as lost.
Whilst conducting research concerning why people invest in pyramid schemes, many of those responding stated that they hope to manage to take themselves out before the fall of the scheme. The only issue being, when exactly this will take place. Sometimes this is associated with panics in the market arising through a financial crisis (as was the case with the fall of the Madoff scheme), and sometimes this is associated with a very irrational type of situation. However, something that is irrational is not necessarily predictable. So, we have to consider that we will not always be smarter than others.
Pyramid schemes are certain attributes, making them identifiable.
What to look out for?
- Above-average returns
Pyramid schemes often offer very high returns in the hope of winning over potential clients: 20% in the course of a month or in the course of a year is standard. Some funds in Poland even offer 300%!!! Even the best “traders” in the world are not able to bring in above-average earnings in the long term (as has been proven by academic research). The sorts of products that offer high returns in the long run are simply not on the market. Why? Investors are smart and start to quickly exploit the situation, which leads to bubbles on the said market, and it inevitably and subsequently bursts. Furthermore, in order to give clients 20% return on investment they have to earn much more in order to sustain their operational costs, which are often very high. Let us remember that in the last several years the market has on average offered 10% gains on investment. If someone tells us that they are in the position to offer higher than the market in the long run, then we should immediately tell them thank you, but no thank you.
- Guarantee of returns
Pyramid schemes also often offer guarantees on returns. However, all investment in financial markets carries with it a certain degree of investment risk. It is necessary to realise that if someone begins to guarantee high returns, we should be in disbelief. From our basic assumptions about finance, such a thing is necessarily impossible.
- Complication of strategy
When we ask the managers of a pyramid scheme how they generate such high returns we often hear that they make use of very complicated financial strategies, or some set of financial engineering. However, complicated investment strategies do not generate above-average risks whatsoever, and they are often a product of high risk. What is more, many strategies mentioned by managers of such schemes do not exist. Furthermore, these institutions also invest in international instruments in order that people from the home country do not understand the investment portfolio.
- Principle of trust
Pyramid schemes never elaborate on their own investment strategies while – at the same time – making transparent their so-called principle of trust. Current financial regulations require that in order for the client to be well-informed both about which products they invest in, they have to know about the institutions underlying such products as well as the implicit risk of such products. Pyramid schemes never do this, as they are not in the slightest a transparent entity.
- High commissions for sellers
Pyramid schemes have a very highly-developed network of sellers and provisional programs for sellers. Amber Gold had departments and stakes in almost every shopping centre, city centre, as well as by every well-known pedestrian zone. How much would someone have to earn in order to hide such high operational costs and at the same time offer 10% returns. Certainly not as much as the market offers. Such financial wizardry simply does not exist.
Furthermore, pyramid schemes often lure people with the opportunity to earn above and beyond. One Polish fund offers extremely high commission on sales (coming to around 20%), provided that someone willingly wants to be committed to investing in it. Nonetheless, the market itself does not offer as much of a farthing of the amounts that would be necessary for this to be possible.
- Aggressive internet-marketing
Many pyramid schemes have a preeminent presence on the internet. They entice viewers with a high number of high-quality advertisements. Everything boils down to attracting the most amount of people possible. Aggressive marketing is then one of their key-characteristics.