A few weeks ago, a reader of this blog commented that the stock market was a Ponzi scheme. I've heard this many times in my career, and I'd like to discuss it in further detail.
Our Securities and Exchange Commission has dealt with many Ponzi schemes over the years. According to the SEC's website :
A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.
With little or no legitimate earnings, the schemes require a consistent flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out.
The key to a successful Ponzi scheme is the gullibility of its investors. Since they never verify the underlying investments in the scheme, or the methodology used to make such stupendous returns, they are inevitably shocked when the house of cards collapses. There are no investments, no controls, no reserves, and most importantly, no ethical constraints.
How does this differ from the stock market? As an example, let's take a company like Coca-Cola. It's a public company, so it's owned by stockholders around the world. It trades on The New York Stock Exchange with the symbol "KO" for about $38 per share (as of Tuesday night).
As a company, Coca-Cola has about $31 billion of net assets (factories, real estate, etc.) and earned a profit of around $8.5 billion last year. It has over 146,000 employees and sells its products in over 200 countries.
So, Coca-Cola is a very profitable company with significant real assets. We could certainly differ on how to price the company, but I think we can agree that it has substantial value. (Based on its stock price, it is currently valued at around $171 billion.)
Now, you might dislike Coca-Cola's products, or its corporate politics, or big business in general. However, my point is that there's a great difference between ownership of a tangible company via stock, and ownership of a phantom.
How do you Ponzi-proof your portfolio?
1. Ask questions. If you don't understand the answer, ask again. Rinse and repeat.
2. Don't let greed tempt you into folly. The higher a promised return, the more skeptical you should become.
3. Know what you own. If you don't understand what you own, ask. If you still don't understand, use a different investment and/or a different advisor.
As the SEC says, "[we] see too many investors who might have avoided trouble and losses if they had asked questions from the start, and verified the answers with information from independent sources." Don't fall into the trap of avarice; do your homework, carry out due diligence, and you'll have a much better chance of success.
Lou Dagen is a Certified Financial Planner in the San Francisco Bay Area. For 23 years, he has helped clients around the world retire in comfort, educate their children, and increase their net worth. If you have questions, please post them in the comments below or call Lou directly at 925-997-8507.
...And advertise your services for free here by disguising the advertising as a blog. And Yes, the Stock Market IS a "ponzi scheme", just that it is a legal one. And if you ever had a 401k, you and your employer were investing in a "ponzi scheme", where your money was pooled with other people's and used to pay off somebody else in the investment scheme. Bernie Madoff made his name off of what he did in the stock market, so did Robert Allen Stanford out there in Texas in 2009. And it isn't the only legal "ponzi scheme" out there, the lottery is another, and so is insurance, too. Money does not magically reproduce itself. It takes more money invested into the scheme to increase the amount in the pot, and knowing that money does not magically reproduce itself, where do you think all those additional monies realized in your accounts come from? From other people who put their money in the scheme and entrusted the people running the scheme. If that isn't a "ponzi scheme", then what is?
Madoff created fictitious account statements, showing large holdings in stocks and Treasury bonds. Stanford created fake account statements, showing large holdings in certificates of deposit (CDs). That doesn't make stocks, bonds, or CDs into Ponzi schemes -- you're confusing cause and effect. Will you pull all your money out of your bank because Stanford listed CDs on clients' statements? The lottery is not a Ponzi scheme either. While the state gets its cut, participants are well aware that they can lose their minimal investment. Insurance is not a Ponzi scheme. It's a method of spreading risk out among a large group of people, who effectively pool their resources together to help out those in the group who suffer. A "legal Ponzi scheme" is an oxymoron. Please re-read the article, and write back here if you want to discuss this further. --- Lou
Typically, only a handful of people (even in sizable companies) are responsible for setting expectations for the future. They all know that "beating the estimates but lowering guidance" will hammer the stock (and their chances of getting that summer home they always wanted). Even relatively honest/ethical people will, at the margin, choose to delay that pain in hopes that the future will brighten before it shows up in the numbers-- so they are systematically biased toward rosy guidance in the face of large potential shifts in reality. This is how a stock loses not 100%, but perhaps 25% or 33% of your money in a few days. When this happens to you, it often hurts just as much as a ponzi scheme....and no amount of due diligence that a small public stockholder can do will protect you.
Therefore, your house ALSO seems to be worth $150K. Do you have more money? No. Was more money "created" (actually or fraudulently)? No. But they value of your asset has increased and you should be able to sell it for $150K of real cash if the market holds up. Stock market works the exact same way, except their are millions of "houses' and they are TRULY identical. No Ponzi scheme.
When you deposit money in a bank, buy a lottery ticket, get insurance or even invest in stocks or bonds, you are basically giving consent, if not implied consent, for the person whom you entrusted your money, to "manage it" as they see fit, sometimes with your consent and sometimes without it. When the money becomes "managed", it turns into a number on a ledger for record-keeping purposes, while the actual money itself gets used in transactions to pay other customers, lottery winners, insurance policy claimants and even other stockholders and bondholders depending on the terms of what they purchased. For example, when you deposit your money into a bank, they take in the money and record the amount taken in from you for their records and yours. But the money itself is pooled with money from other depositors and then loaned out to a customer to buy a car or a home and if that loan were backed with guarantees of payment by FHA, VA, HUD or whoever, once the bank got paid, then the depositors got paid a small usury fee (called interest) for allowing their money to be used in this manner, just like a Carlo Ponzi would to his customers. As for the money that was lent out, it would be up to the guarantor (FHA, VA, HUD, etc.) to work with the borrower to pay that loan back.
In a Ponzi, investments are FICTITIOUS ... they do not exist! Everything you mentioned is a real asset: bank accounts, lottery ticket, insurance, stocks, bonds are all tangible and have real worth. Most Ponzi schemes claim to control real assets. The fraud lies in that the assets don't really exist; the only way to give investors their money back is to take in new money. May I respectfully suggest you watch "It's a Wonderful Life." Remember when the mob stormed the Bailey Building and Loan bank, convinced that their money was irretrievable? And George Bailey had to explain to them that the community WAS their money? That's capitalism, and a healthy economy ... not a Ponzi scheme. --- Lou
And much like Carlo Ponzi's scheme, much of that is dependent on the gullible people who purchase their tickets, regardless of whether they win or lose, which most of them do lose, so that the money can be kept to pay the winner and keep the operation going. As long as there are gullible people playing, there is always money coming in. And that's a "Ponzi Scheme"--"Peter/Petra" had to be lured into playing so that "Paul/Paula" could be paid if they won the prize. And with a state-sponsored Lottery, the state is involved, either directly or indirectly in the scheme, guaranteeing that the prize would be paid to the winner, but yet collecting the proceeds from the players and the losers of the Lottery for their own means, so in that scenario, this is either state-sponsored "theft" or a "tax" on those who play. And if you have more poor people than rich people playing the state lottery, then you pretty much have the poor paying a tax because they are poor as well as poor people pooling their monies together to make one poor person rich.
1. In a Ponzi scheme, all "investors" expect to receive their principal back, along with a high rate of return. In a lottery, all players know there's a good chance that will receive nothing, and lose their "principal" (the ticket price). 2. In a Ponzi scheme, all "investors" believe that everyone will receive a handsome profit. In a lottery, all players know that most will lose, and only a select few will win. 3. Most importantly, in a Ponzi scheme, all "investors" believe that there are actual assets at work. In a lottery, all players know (or should know) that the proceeds received from ticket sales act as collateral for the eventual prize payout. If you don't believe me, please go to the Securities and Exchange Commission site (link is in my post). If you don't believe the government either, look in Wikipedia. I think any lottery is a waste of money, designed to raise revenues for the government, at the expense of players, taking advantage of their ignorance of probability and finance. However, a lottery is not a Ponzi scheme. --- Lou
And that is because when one buys insurance and pays their premium, they are making a bet. The insurance carrier is betting that some day, the policyholder/premium payer is going to have an accident/need medical care/die/or whatever terms were agreed for this money in the bet. As long as the policyholder/premium payer agrees to the terms under which their end of the bet was made, if and when they have their misfortune, the insurer agrees to pay, providing that any and/or all the terms and conditions of the bet (or policy) were met. Now in order for the insurer to meet those terms, they have to have a scheme set up just like Ponzi set up, where the monies that the policyholders/premium payers paid is pooled into reserves, to pay up on any claim, as well as any fees to manage the scheme and the company running it. And sometimes, the reserves held by the insurer don't add up to all the claims (aka "exposure") being made by the claimants, as we saw time and again over issues like Asbestos claims on CGL policies and even environmental issues, where the government had to come in with its own guarantees like CERCLA and its "Superfund" to ensure that the environmental issues would be cleaned up, and then go after the PRPs and their insurers to replenish the monies the government had to pay. Ponzi would have been proud to take in the premiums and just not pay on the claims.
Like the lottery scheme, the gullible people pay into this one in the hopes of a big payout. And just like all the schemes out there, it requires a lot of gullible people out there to pay into it, so that the monies can be pooled together, invested and so the monetary amount becomes a number on a ledger and the money itself goes off to pay other investors in the forms of interests and dividends and as long as there is all this money coming in and some people are getting paid, very few questions are asked about how things are run and what happens when the stock market has a very bad day. But when that does happen, the numbers in the ledger then change drastically, usually for the worst and the money invested is lost because somebody else got it in whatever investment or bet that they made. And this is usually when a Madoff or a Stanford get found out that all was not as it seemed with the way they were managing their customers' assets and that as long as there were gullible people out there convinced to invest with them in good times, they didn't have a problem until it was discovered that there was not enough monies in their reserves to cover all their customers' assets entrusted with them, once again using the monies "Peter/Petra" invested to pay for "Paul/Paula"'s dividends and returns.
And that is the nature of the transaction. And from the scheme's sponsor, that "fiction" is a reason to market and sell the investment and that if the sponsor lures enough investors in on that "fiction", then perhaps some money can be made by everybody who invests, or by some people who invested, all the while the sponsor is making their money for sponsoring the scheme regardless of whether or not some or all their customers/investors are making money in the scheme. The biggest problem with the Stock Market Crashes of 2008 were that up until August 2008, it was being reported that crashes like 1987 and 1973 and even 1929 before them could not happen because so much of "main street"'s people invested their money through their IRA's and 401(k)'s and that with all these people's monies pooled together it would make for a stabilized market. It didn't. Instead, it proved "easy pickings" for those that could profit from the losses in August and September of 2008, where 1/3rd of the monies invested just upped and disappeared. Money that a lot of people hoped that they could retire with someday in comfort. Because once again, the gullible people out there got oversold on the advertising of this scheme.
"You can't win if you don't play." And once again, it is the fiction generated by the lure of easy money and instantaneous gain, all on the hopes that the lottery ticket this gullible person bought, believing that if they played, they had a chance of winning. And once again, if enough people were gullible enough (cue the famous P.T. Barnum adage), not only would it increase the amount of money one could win, but also increase the amount of money that the scheme's sponsors would ALWAYS be making in this scheme, no matter who won or who lost playing in this scheme. And that's definitely a "Ponzi Scheme". And when the state is involved in this scheme's sponsorship, no matter how benevolent their intentions, they are still preying on the people gullible enough to buy tickets on that fiction that they too could win if they played. And in a lottery scheme, a Carlo Ponzi would be there running it, promising the winner a big payout, skimming his monies from the pool everybody that bought a ticket paid into. And one of the things we hear about in the news is always the big payout, but very little attention is paid to all the people that paid for tickets and what other fees were paid out or taken out by the sponsors of that lottery. All based on selling the fiction that a person could win just by playing.
I don't think its Lou's intention to suck you into a ponzi scheme....There are fabulous companies making great returns and offering fair value..There are mediocre companies out there also along with some bloated and inflated stocks. If I read his article correctly is do your homework and ask questions... This Country was built by great Business.Everyone can't work for the Government.
If you have seen "Justified" thus far, you probably recognize the scene by which that line comes from. And that is how this Financial Planner is coming across to me--like some "tent revival snake-handling preacher" wowing his crowd with his ways of word and now letting the "faithful" trying to sell us his version of "salvation". The reality here is that you can't trust this person with his financial advice any more than you can trust any other person out there that calls themselves a financial advisor, whose advice may not be any more sound than your next-door neighbor's, even if they happened to be financial planners themselves. And when this particular financial advisor is telling us about how to "Ponzi-proof" your investments, always be aware that Ponzi Schemes are not always going to "stick out like sore thumbs" and be easily identifiable as Bernie Madoff proved, when it was found out he was operating his scheme since the early-1970s and it wasn't discovered until 2009, when he first confessed to his sons who were about to inherit his business all the great wrongdoing that he did to his customers. And ultimately it was the sons of Madoff who turned him in to the authorities, because they, like the rest of the financial community, had no clue that Madoff was running a Ponzi Scheme.
If I thought I could make a safe, decent and stable return doing so, I would keep all my assets in the form of gold bars stashed in a safe somewhere. But I can't, so I am forced to take on lots of flavors of risk which, by my estimation, are better on a risk/reward basis than betting on the price of gold over the next few decades. In general, I am all for ranting, but your Perpetual Ponzi Protestations are kinda getting old.
And when it comes to money matters, there is this Latin phrase that one should always keep in mind--- "Caveat Emptor" Translated into English, albeit idiomatically but then again most translations are based on idiomatic interpretations that the interpreter brings into their interpretation, it means "buyer beware" or "let the buyer beware". And in forums like this, advice is always cheap, even from a source like me, the host of this forum and even you, Mr. Nicholson. You can always take the advice you want, set aside what you don't, and believe what you want to believe. But be prepared to encounter skepticism, cynicism, optimism even along with some ranting and rancor, praise and castigation in any writing, especially where some sort of advice is being put forward, promulgated, or even proselytized and prophesied. And if somebody wants to sell you salt, make sure it isn't urine with the water taken out of it, which in turn could prove to be more hazardous to one's health than the salt would be because of the other chemicals that may be present and that could be toxic.