A pyramid investment scheme is one based on false accounting. It is one of the oldest tricks in the book.
If you put money into an investment scheme they will take your money and invest it in a variety of shares / commodities / bonds e.t.c. The hope is that the investment fund will choose good projects and therefore give you a better return on your money. Sometimes investment trusts may do better than the stock market and other investments, but sometimes they may do worse. At the end of the year they will make payments to the original investor.
A pyramid scheme may not invest in anything at all. However, at the end of the year, they will use new subscriptions to pay the people who joined at the start. If more people keep joining then the investment scheme can always use the new inflow of money to pay existing investors and give a guaranteed profit. Therefore, from the outside it can look as if the investment trust is every year making a guaranteed return. This encourages more people to join and so the pyramid scheme can keep going.
However, the problem is the pyramid investment scheme is built on a sham. It has never invested any money. New people’s money is being used to pay the returns for existing customers so in effect the investment trust has immediately given away all the income from the new people joining. So their investments are worthless.
What Causes A Pyramid Scheme To Collapse?
When new people are joining, the annual returns can be paid. But, if less new people start to join, then the firm has a cashflow and cannot make decent returns. IF people then start to leave, the investment trust will be left with a large black hole and many investors will not be able to get their money out.
In the case of Bernard Maddoff, it was the credit crunch which caused his huge $50 billion scheme to come crashing down.
If you watched Little Dorrit on BBC, you would also have seen a pyramid scheme come crashing down. – see: Dickens and Financial Scams