An investment scheme collects money from the investors and invests it in assets that generate some amount of return. This return is then passed back to the investors after deducting for expenses and commissions.
In a Ponzi scheme, an illusion of a successful business is built by passing on money brought in by the later set of investors to an earlier set of investors. And the scheme keeps running till the money being brought into the scheme is greater than the money leaving the scheme.
This process of rotating money to hoodwink investors has been used fairly successfully over the years. If one may borrow a French phrase, plus ca change, plus c'est la meme chose (the more things change, the more they remain the same).
The details might change from scheme to scheme, but the structure abides. And it is now making a comeback through illegitimate multilevel marketing (MLM) schemes. The link between illegitimate MLM schemes and Ponzi schemes is what I hope to explain through this article.
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In a legitimate MLM scheme, a company appoints independent distributors, who are not employees of the company. The products of the company are sold to the distributors, who not only sell these products to make a profit, but also appoint more distributors and so the cycle goes on.
In a legitimate MLM scheme, like Amway and Avon, the returns are from the commissions of one's own sales, commissions on the joining fees of the new distributors that one recruits, the commissions of sales of those one recruits and their recruit dependants.
An illegitimate MLM scheme is effectively a Ponzi scheme. Much like the chain letter schemes that most of us must have encountered during some point in our lives.
In an illegitimate MLM scheme, the company goes about appointing distributors, but the catch being that the products the distributors buy rarely get sold. The product is incidental to the entire process and is essentially used as a fašade to run a Ponzi scheme.
The entire commission of the distributors comes from appointing new distributors to the company, thus creating a new level. The new level that is created is expected to create another new level. And so the scheme goes on, with newer levels being created.
The return to the upper levels comes from creating new levels rather than the sale of the product. The wealth gained by participants at the higher levels is the wealth lost by participants at lower levels.
And to keep the scheme running more and more people have to keep entering it. Like in any other Ponzi scheme, there are only a finite number of people who can enter the scheme. So after some time such a scheme goes bust and the people who had started the scheme, simply disappear, leaving the investors in the lurch.
The success of MLM companies like Amway and Avon has seen a lot of illegitimate MLM schemes crop up in the recent years. Such schemes claim to be selling anything from diamonds to stainless steel utensils to television sets.
Off late, some of these schemes have started appearing on the Internet. Since such firms do not have a physical presence, they cannot be tracked.
The fact that all this sounds so obvious in retrospect raises the question, 'Why do people still fall for it?'
The reasons for the same are elaborated below:
Can't say no
Most of the people getting into illegitimate MLM schemes are introduced to these schemes by people whom they know very closely.
It might be a relative or for that matter a very close friend. Given this, even if the investor is not convinced about the entire thing, he might still decide to go ahead and become a part of the scheme, just to keep the relationship going.
Monkey see, monkey do
Robert Shiller in his book, Irrational Exuberance, says, "A fundamental observation about human society is that people who communicate regularly with one another think similarly. There is at any place and in any time a zeitgeist, a spirit of times."
At any point in time people are influenced by people around them, their acquaintances, neighbours or relatives. Psychological research shows that desire to conform to the behaviour and opinions of others is a fundamental human trait. So if everybody around is investing in a particular MLM scheme the tendency for people is to get into that scheme.
Furthermore, the decisions of investors whether to get into an MLM scheme are not made at the same time but in a sequence.
Much like the circular mill of ants. Ants when they get separated from their colony, obey a simple rule 'Follow the ant in front of you.' People who invest in the illegitimate MLM scheme assume that the scheme is a good bet simply because some of the people they know have already invested in it.
So everyone ends up making the wrong decisions because the initial investors get into the scheme by chance. More and more people want to become rich without really understanding the process involved. When the rest of the world is going mad, the investors must imitate them to some extent.
As Adam Smith asserted, "Emulation is the most pervasive of human drives." Also, the potential investor will look foolish if he lets a good investment opportunity go by.
As Keynes wrote, "Worldly wisdom teaches us that it's better for the reputation to fail conventionally than succeed unconventionally."
The attraction of easy wealth is something that investors cannot resist. Illegitimate MLM schemes promise huge returns in a short period of time vis-a-vis other investments available in the market at that point of time.
With stories of previous investors who made a killing by investing in the scheme, investors get caught in the euphoria that is generated and hand over their hard earned money to such schemes going against their common sense.
Greed also results when investors see people they know make money through this scheme. As Charles Kindleberger wrote, "There is nothing so disturbing to one's well being and judgment as to see a friend get rich."
In a country like India where the per capita income is low and around a quarter of the population lives below the poverty line, the chances of people falling for illegitimate MLM schemes are even higher.
Overconfidence and over-optimism
Researches in psychology shows, most people rate themselves high on most of their positive personal traits. People are also overconfident about their ability to make accurate estimates. They generally tend to be over-optimistic when they are directly involved and have had no negative experience from the over-optimism.
They are overconfident that they themselves will not be victims of financial frauds. That is why they do not ask the obvious questions. Overconfidence and over optimism together fuel such illegitimate MLM schemes.
In uncertain situations, people tend to look at the familiar past pattern and assume that the future patterns will be identical to the past ones.
Since the investors do not know exactly what will happen tomorrow, it is easier for them to assume that the future will be similar to the recent past than to admit that it might bring in some unknown elements. If the going has been good in the recent past, investors feel that this will continue in the days to come.
The attraction of an offer can be increased significantly when contrasted with a similar but worse alternative.
All of us who have ever gone house hunting will swear by it. Agents first take us to a house in a bad shape and then immediately after that take us to a house that is a little better than the first house.
But the price quoted in the second case is always overstated. The contrast effect becomes relevant in the context of an illegitimate MLM scheme when the prospective investor starts comparing the returns on the various schemes available in the market for investment at that point of time. The high returns of the scheme stand out clearly and attract gullible investors.
The Greater Fool Theory
At times, investors might understand that the MLM scheme is nothing but a Ponzi scheme, but they would still be willing to enter the scheme, because they feel that some greater fools could be depended on to enter the scheme after they have and this would give them good returns on their investments.
Over the years, investors have been fooled into investing their money into illegitimate MLM schemes, which keep appearing in various forms.
Investors ignore the most fundamental principle of investment: One cannot expect to make large profits without taking risk.
Whenever a large amount of money is at stake, individuals should logically seek large amounts of information on where they should invest.
But most investors do not do so. Few ask the right questions at the right time and are naive enough to believe in what is communicated to them by the people carrying out the fraud. Indeed, many illegitimate MLM do not get reported, as people do not like to admit that they have been fleeced because of their greed.
The ones which are reported and investigated get stuck in the quagmire of our legal system. And those who do get convicted are let off lightly, as happens often in white-collar crimes. This encourages more people to run such schemes.
The author is Research Scholar, ICFAI University.