Tuesday, November 13, 2007

Personal Finance Part 5 – Multi-Level Marketing or Ponzi Scheme ?

This topic on multi-level marketing (MLM or network marketing) has come up more frequently these days in the Straits Times when they reported on a company known as Sunshine Empire. Apparently, this company is becoming more and more high profile and the founders are conducting dubious activities to try to recruit more people to join the company to promote its products and agenda. MAS recently had issued a warning to the general public to be wary of such companies. But just what exactly is a network marketing company, and is the business model sustainable or profitable ? Let’s explore this concept and compare it with a classic pyramid scheme (a.k.a. Ponzi Scheme).

A network marketing company makes use of a network of sales people in order to sell a product or set of products. The recruiter will recruit say 4 people (called the down-line) to buy a set of products to start off the network, and these 4 people in turn each approach 4 other people to become their down-line, selling the products to them in turn and so on. It all sounds very feasible as long as there is a genuine product and there are enough down-lines to support the commission structure for the recruiters. The scheme can continue as long as there are end-users buying the products, thus enriching the sellers who were the original recruiters. Such a network marketing scheme is legal and legitimate as the money flows in from parties who purchase and use the products, and not solely from new recruits. Most MLM companies require an upfront “investment” in the company’s products, after which you will become a member and can then sell the products to another salesperson or an end-user. Commission is then paid to the salesperson based on the value of the products sold.

This all sounds well and good but the problem is that there are companies which operate in the same manner, minus the actual physical products. These are called pyramid schemes and are unsustainable in the long run. The modus operandi of such companies is that they will promise a very high (and unrealistic) return on investment to all who “invest” in the company. This might range from anything like 100% per annum to 1,000% per annum and these claims entice people to throw their money into the company. As more people join, the early birds can paid from the monies invested by those who join later, and the promised returns really do accrue to these early birds. However, it has been calculated that the entire scheme is unsustainable after 12 levels of recruitment as it would require the population of the entire Earth to sustain the ridiculously high promised payouts ! This scheme was first mooted by Charles Ponzi back in 1920 in the United States, and it was essentially the same method (read about him in wikipedia.com). It has been proven that about 88% of all people who join a Ponzi scheme will lose essentially all or a large part of their investment, with only the initial 12% becoming fabulously rich. In essence, this is the ultimate re-distribution of wealth (by the way, lotteries such as Toto and 4-D also do this, albeit in a more organized fashion) and most of the wealth gets distributed back to the original founders of the scheme.

In the case of Sunshine Empire, the chairman Mr. James Phang (who, incidentally, was also involved in a dubious company marketing a product called Number One Product) made claims that he was “better than Warren Buffett” and could promise returns as high as 10% per month, which was in essence 120% per annum. It should be noted that Mr. Buffett himself, being the greatest investor and wealth builder who has ever lived so far, has only managed about 23% per annum for 30 years. Thus, there is no doubt that the wild claims made by this company are fraudulent and stink of arrogance. Anyone who is remotely financially literate would have viewed this as the scam it was as there was no real product involved but merely a case of redistributing wealth from new joiners to those who had joined earlier. An “investment” of $10,000 could yield $1,000 within a month, but there is no possible way for this to be sustainable in the long-run as pyramid schemes all collapse from their own weight after a while, leaving almost everyone poorer.

So why do these schemes still exist, and why are they still so popular (Sunshine has “recruited” close to 20,000 people and counting) even though it has been tried so many times ? The simple reason is that people, being human, are ALWAYS greedy and wish for quick returns for hardly any effort at all. Suffice to say that this is what I despise most: people who want instant large rewards without putting in any requisite effort whatsoever. Another factor is the level of financial literacy; most laymen with no knowledge of investment returns would automatically think that 10% per month is a great deal without considering if it was sustainable or even possible. A third reason is that it is not easy to distinguish a legitimate MLM company from a Ponzi scheme, and it usually takes the relevant authorities some time to investigate a company’s activities before it can make a conclusion.

In the meantime, I would advise readers to be very wary of claims of inflated returns. Equities can give you an average return of 10-12% per annum over the long-term, while super-investors such as Warren Buffett or Peter Lynch can manage much higher rates of return at 16-20% per annum consistently. If you ever hear of a claim which says 40-50% per annum consistently, then there is a very high chance that it is a scam !

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