A Byte of my 2.2-lb Brain

Just sharing stuff…

Thinking through pyramid-like business schemes

Reposting as is. This article was originally published on 07 Feb 2013 (Philippine) STAR Science.

Exploitative pyramiding scams masquerading as legitimate multilevel marketing (MLM) schemes have once again evoked the attention of our government regulators and lawmakers, especially with the recent investment racket involving Aman Futures Group that allegedly conned some 15,000 individuals across the Visayas and Mindanao regions out of P12-15 billion. This is not the first time that massive fraudulence through investment scams has plagued our society. In 2003, the New York Times reported a case involving about a million Filipino investors, mostly OFWs and their families, who lost over $2 billion in a pyramid scheme backed by a company called Multinational Telecom Investors Corp. (Multitel). Four years later, another investment scam disguised as a high-yield investment program was exposed. FrancSwiss was a Ponzi scheme that swindled Filipino investors out of P1 billion in valuations. The list goes on, and one would actually think that we would have already learned from these frauds. Unfortunately, such is not the case. Last December, the Securities and Exchange Commission (SEC) issued yet another warning to the public about an investment scam operating in Cagayan province, Ilocos Norte, and Camiguin that particularly targeted domestic helpers — promising them a P900 profit every month for every P100 investment made.

It is not really surprising that these scams continue to thrive in our society despite all the publicity and warnings regarding these grievous incidences. We are a people composed of individuals and families who dream of overcoming poverty and rising up the economic ladder in the quickest and easiest way possible. This is why many find get-rich-quick schemes quite attractive. This is also why pyramiding scams and Ponzi schemes have not only afflicted our economy, but other emerging economies worldwide as well.

Illegal “multilevel markets” such as pyramiding and Ponzi schemes can be very appealing, especially with their claim of “unbridled growth” with regard to network membership that go hand in hand with a perceived promise of profit, i.e. individual earnings are dependent on his/her number of recruits. This is how it works: you recruit two individuals; these recruits, in turn, then recruit two more each, and so on and so forth. After some level down your network, say for example five levels, there would have already been 32 (=25) people under you (also referred to as “downlines”). Additionally, if you would be earning commissions from each of these “downlines,” that would be a pretty hefty amount of premium you would be raking off. Without putting in that much effort, you are guaranteed of rewards that can be quite staggering. What more can one ask for? With the opportunity to earn without even having to sell anything, just by mere recruiting, these schemes seem to be such lucrative ventures.

Too good to be true? Unfortunately, they usually are.

In 2008, our research team at the National Institute of Physics, University of the Philippines Diliman published a paper titled “Earning potential in multilevel marketing enterprises,” which was also part of my undergraduate and masters theses. We were specifically interested in validating the claim of unlimited “exponential” growth of various pyramid-type of businesses and evaluating their earning potential. As a first step, we investigated the network growth dynamics of certain types of MLM companies by looking into the social network fabric of “friends” and “acquaintances” of individuals, which is central to MLM operations. We set up an agent-based model (simulation) of the system — from the individual recruiting agents to their relationships and interactions that essentially governed the recruitment rules in our study. Furthermore, our simulated society was built to exhibit the “small-world” property that took into account what is observed in real world social networks. The term “small-world” refers to the property of social networks where any two people in the world can be connected to each other using only a few “relationship links” (think mutual friends and six degrees of separation) and that they are highly clustered (think how people always form cliques and how your “friends” are also “friends” with each other). The “small-world” property, which was previously only a speculation, has already been empirically observed and experimentally established.

One of the key results we found was that MLM membership growth “decelerates after reaching a size threshold, contrary to claims of unrestricted growth.” The network does not grow continuously and exponentially, but slumps down after some threshold level. This resulting growth dynamics was also observed in the data that we collected from an actual MLM company. One plausible explanation behind this phenomenon can be attributed to the “small-world” property of our social network. As mentioned above, social networks are “highly clustered,” i.e. your friends are most likely to be friends with each other, too. How is this relevant in MLM operations? To illustrate, imagine having five friends who are also friends with each other. Once you recruit all five of them, they all would have no one else to recruit, at least none within your circle or clique; or they would have five (including yourself) less people whom they can actually recruit. Into the bargain, in small cities, communities and/or barangays, this clustering is especially expected to be higher, and the “world” becomes much “smaller”; that is, everyone seems to already know everyone else. What this fundamentally tells us is that people will eventually run out of friends, relatives, and/or acquaintances to recruit more quickly.

Given this premise, it has to be understood that if certain networking schemes depend solely on network membership growth (recruitment process) as means to make money, they are inevitably bound to collapse; that is, you will run out of “friends” and “acquaintances” to recruit. Regrettably, people situated at the lower levels of these networks are the ones who are most affected. In fact, in our work, we also showed that the “earning potential of (certain MLM architectures obeys) the Pareto “80–20” rule, implying an earning opportunity that is strongly biased against the most recent members.” This basically says that 80 percent of the wealth of certain MLM companies is owned by only a measly 20 percent of its total members — the top 20 members.

It must be noted, however, that there are legitimate MLMs, which are quite different from pyramiding schemes (illegal ones). Notwithstanding the fact that they both have close operational and structural resemblance (“multiple levels’ of distributors and recruits”), authorized multilevel marketing companies have actual products and/or services of good value to sell, e.g. Tupperware, Herbalife and Avon. Furthermore, their distributors earn most of their profits from product sales and not much, if none at all, from the recruitment process. The recruitment process in legitimate MLMs is just a marketing strategy conjured to help reduce advertising costs by taking advantage of the power of social networks; that is, it is easier to “spread the word” in a “small” and highly clustered community. Furthermore, word-of-mouth marketing tends to be more credible and more targeted than the more traditional forms of advertising (e.g. TV and radio ads). On the other hand, in pyramiding and Ponzi schemes that pose as legitimate MLM businesses, only the recruitment process is there but there are no products and/or services of good value to sell.

In 2002, the SEC released an advisory that was “intended to help the innocent investor with some money to save distinguish between what is legitimate, and what is an area where even angels should fear to tread.” In the SEC booklet, pyramid and Ponzi schemes, together with legitimate MLMs, are defined comprehensively. The legality and illegality of these schemes are also discussed and explored. Furthermore, the booklet offers ways on how one can evaluate various pyramid-type offers. It is a highly recommended read, especially for individuals who have received and are receiving invites to join multilevel businesses but are doubtful about the legitimacy of these businesses.

Remember, as the cliché goes, “if it sounds too good to be true, then it probably is,” especially when it comes to money and business.

* * *

Erika Legara obtained her undergraduate and graduate degrees in Physics from UP Diliman, garnering the Most Outstanding Graduate Student Award and the Edgardo Gomez Excellence in Dissertation Award when she was conferred her Ph.D. degree in 2011. She specializes in the areas of complex networks and computational social science. She has been a member of the Complexity Science group of the UP National Institute of Physics since 2004 and is now doing post-doctoral work at the Agency for Science, Technology and Research in Singapore.

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This entry was posted on February 4, 2017 by in Blog, Investing, Philippines, Uncategorized and tagged , , , , , , , , .
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