How to tell a pyramid scheme from a real investment

Many people are exposed to get-rich-quick schemes the world over. South Africa, in particular, has seen a lot of such money-making schemes over the past few decades.

The appetite for investment opportunities that promise "high returns" remains high, and anything that can meet this insatiable demand will definitely find buyers.

With a lack of enforcement of regulation, schemes where the potential to make money is deemed very high have evolved. Some are pyramids, and others use goods and services to lure unsuspecting investors. Some sell cosmetics, some sell services, and they are sometimes called "multi-level marketing".

The marketers of these schemes aggressively defend them as not being pyramid schemes.

Pyramid scheme members at the top benefit the most and those nearer the bottom only benefit after top members have been paid.

New members must be recruited to ensure existing members are paid and this is the main source of income rather than value created from a product or investment. When new members can no longer be recruited fast enough, the scheme inevitably collapses.

It is good to be able to differentiate between an investment and a pyramid scheme. Quick and huge returns are more appealing than the prospect of making long-term returns, but while you may perceive one of these schemes as the shortest route to wealth, they could in fact cost you all your money.

Investment returns

Bigger than normal returns is one way to identify a pyramid scheme. It may offer as much as 5% per day, or 30% per month.

As a general principle, a product that offers returns above 30% a year is abnormal and, therefore, is a pyramid scheme.

The lack of regulation in this space means promoters do as they please when setting expected returns, and there are no legal consequences when the scheme fails and investors lose their money.

You will only be guaranteed a return on any legitimate investment monitored by the Financial Sector Conduct Authority (formerly the Financial Services Board), if it is a fixed income one.

Banks usually do this quite well - their 60-day notice deposits are an example. Government retail bonds also guarantee fixed returns on certain amounts over a certain period.

Other investments such as shares and unit trusts, for example, do not promise any returns when sold correctly by professionals, carry a full risk warning stating that you can lose your investment as the value of such securities depends on the market, and the company's performance. The risks are fully communicated so you, the investor, can make an informed decision. Steinhoff, African Bank, Aveng, Group Five and Impala Platinum are examples of stocks whose values were significantly reduced over time. But investors always knew the risk of loss of capital as it was communicated.

Pyramid schemes, however, promise unrealistic returns and should be treated with caution.

Requires you to invite others to join

This is perhaps the common giveaway for a pyramid scheme. Its success depends on new members joining the scheme with new money to keep paying those who joined first. Schemes often ask members to bring three participants, and each new member in the scheme has to focus on bringing new participants.

Once everyone who falls for the scheme has joined, it will eventually collapse as there is no more cash injection. This is why schemes don't survive forever.

Companies promoting normal investments do not carry such invitations for other people to invest. Instead, as an investor, you will be told the risk of loss and the potential to earn returns, whereas the pyramid scheme pushers conceal the reality of potential losses.

Services and goods attached to schemes

These days, as a measure of reducing scepticism around such schemes, promoters usually introduce products or services that go with the scheme, and people get a sense of comfort because they have a holiday package, or some drink that can help reduce weight, to sell. Be cautious if the traits outlined above are reflected in the scheme, regardless of the goods and services attached.

People should continue to invest in long-term capital growth, and avoid being taken for a ride by such unethical schemers.