WHY PYRA­MID doomed SCHEMES ARE TO FAIL

Ev­ery­one is feel­ing the pinch, but a deal that sounds too good to be true must be avoided at all costs, writes Mike McDougall

CityPress - - Tenders -

Faced with empty wal­lets and an in­creased cost of liv­ing, thou­sands of South Africans are plac­ing their faith in get-richquick schemes, which lure des­per­ate con­sumers with prom­ises of un­re­al­is­tic in­vest­ment re­turns. But whether it’s a Ponzi or a pyra­mid scheme, it can be math­e­mat­i­cally proven that such schemes will even­tu­ally col­lapse and leave in­vestors with noth­ing.

Ponzi and pyra­mid schemes are in essence the same thing – both rely on con­tri­bu­tions from new in­vestors to pay ex­ist­ing in­vestors the promised re­turns. These are usu­ally to­tally un­re­al­is­tic and not com­pa­ra­ble to re­turns achieved by le­git­i­mate sav­ings and in­vest­ment prod­ucts.

While in­vestors in a pyra­mid scheme know that they need to re­cruit new mem­bers to main­tain the flow of funds, Ponzi schemes claim to make le­git­i­mate in­vest­ments, but in­stead use the funds to en­rich founders rather than use them for any le­git­i­mate busi­ness pur­poses.

It can be stated with ab­so­lute cer­tainty that these schemes will even­tu­ally col­lapse, leav­ing many peo­ple fi­nan­cially des­ti­tute, while only the founders and a few early par­tic­i­pants make con­sid­er­able gains.

There are two rea­sons for this. Firstly, if a scheme is pay­ing out more than is be­ing earned, it will run out of money.

Se­condly, such schemes con­stantly need new mem­bers to join in to sus­tain pay­ments to ex­ist­ing mem­bers, and the re­al­ity is that they will ul­ti­mately run out of new in­vestors.

The only un­cer­tainty is when the col­lapse will hap­pen, which de­pends on how quickly the fund is grow­ing and how much big­ger the de­clared yields are than the ac­tual in­vest­ment earn­ings on the funds in­vested.

Say a scheme be­gins with 100 mem­bers, who each in­vest R1 000 with a promised re­turn of 30% a month. Every month, 100 new mem­bers join the scheme and each in­vests the same amount.

Mem­bers re­ceive their first pay­ment the month af­ter they make their in­vest­ment. In this ex­am­ple, the scheme be­gins with 100 mem­bers and to­tal funds of R100 000. In the sec­ond month, there are 200 mem­bers and the fund closes with R170 000 af­ter pay­ing div­i­dends of R30 000 to the found­ing mem­bers.

The to­tal div­i­dends paid rapidly es­ca­late each month as the mem­ber­ship base in­creases, un­til the scheme reaches its sev­enth month.

In its sev­enth month, the scheme be­gins with R70 000 and re­ceives an ad­di­tional R100 000 from new in­vestors. How­ever, the scheme must now pay to­tal div­i­dends of R210 000 to its mem­bers, leav­ing it R40 000 in debt. In­stead of R300, each in­vestor only gets R243 and the scheme col­lapses.

With more rapid growth in mem­bers or lower pay­outs, the scheme would con­tinue for longer, but the re­sult would ul­ti­mately be the same.

As pyra­mid schemes rely on snar­ing new mem­bers, you should be wary of be­ing daz­zled by sto­ries of high re­turns by peo­ple al­ready in a scheme.

The re­al­ity is that by the time you join a scheme, you may just be prop­ping the scheme up so that early join­ers can profit at your ex­pense.

You and other new in­vestors may never re­coup even your ini­tial cap­i­tal amount, let alone make a re­turn on your in­vest­ment.

DIF­FER­ENCE IN RE­TURNS BE­TWEEN EARLY JOIN­ERS AND LATE JOIN­ERS

If you were a mem­ber who en­tered the scheme at its in­cep­tion with an in­vest­ment of R1 000, you would have earned to­tal re­turns of R2 043 by the sev­enth month, when the scheme fails. This means that your re­turn would have to­talled an over­whelm­ing 22% a month.

How­ever, if you had only joined the scheme in its sixth month, you would only have earned R243 back on your in­vest­ment, rep­re­sent­ing a loss of 76%. If you had en­tered in the sev­enth month as the scheme col­lapsed, you would have lost your en­tire in­vest­ment.

Those en­ter­ing the scheme early can there­fore make spec­tac­u­lar re­turns de­spite los­ing all their cap­i­tal, while those join­ing later lose money. It’s a clas­sic ex­am­ple of rob­bing Peter to pay Paul.

The peo­ple who get in early are usu­ally the founders of the scheme and those close to them.

McDougall is CEO of the Ac­tu­ar­ial So­ci­ety of SA

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