Friday, August 10, 2012

Are stocks a Ponzi scheme?

The premise behind investing in stocks is simple: buy low and sell high. You should be wondering, why should stock prices increase at all? Ultimately the reason is because other investors want to invest in it, in hopes of selling their shares at an even higher price than what they paid for.

But wait, isn't this just an elaborate Ponzi scheme? Let me explain.

Puts Nigerian scammers to shame

Ponzi Schemes

For those who are not familiar with the Ponzi scheme, it is a rather simple, yet clever scam. It is named after Charles Ponzi (1882-1949) who successfully employed the scheme to scam thousands of New Englanders back in the 1920's [1].


The scheme starts with a claim of an investment opportunity with lucrative returns (like 50%/month), open to anyone who wishes to partake in it. Initial investors are drawn in by the prospects and unsuspectingly throw some money into the pot. As more investors do this, the early adopters are given their expected returns using the money of later investors.

With the increased confidence, many new investors are drawn in and the cycle repeats itself. The bandwagon effect takes over and before long, the initiator of the scam ends up with a huge sum of cash and a lot of debt.

At some point, the scammer will simply disappear with all of the invested money, leaving everyone else penniless. You may think that the early adopters still came out ahead (since they received their promised returns); however it is usually precisely those first investors who come back and reinvest even more money into the scheme.

Stocks are not Ponzis

As you can see, the stock market shares many of the same characteristics as a Ponzi scheme. Money is put into an security whose returns are backed by the investments of future investors. Eerily similar isn't it?

However, it is important to realize that the entire scheme is only a scam because it eventually unravels and the truth comes out. The mechanism behind this is usually caused by a slowdown of new investments. Once the fraud has been saturated as much as possible and people start asking for their returns, there is no one left to turn to. At this point, investors would realize the issue and attempt to withdraw in what is similar to a bank run. Unfortunately it is usually too late and the money is already gone.

A stock on the other hand is backed by a real physical asset: the company and its business. If a company has $1 million on hand, the stock price should never drop below that million divided by the number of shares outstanding. So as long as a stock price stays in check and close to reality, there is little risk of it becoming a Ponzi scam.

sometimes...

Unfortunately this isn't always the case as has been proved many times throughout the course of history. The dot com bubble was forged around the basis that the Internet was an infinite source of wealth. Investors believed that each up and coming dot com company would be the next best thing and was worth putting money into at any price. This only fueled the delusions even further until finally the bubble popped in March of 2000.

Aaand the bubble pops
When this happened, even the largest and most successful companies suffered catastrophic losses in value. The online retail giant Amazon.com fell almost 95% from $106 per share to just under $6 per share. Other companies hardly fared any better and many did not survive.

The recent subprime mortgage crisis occurred in a similar fashion as houses became the new investment fad. Reckless investment behavior led to unreasonably high housing prices. Houses were being bought on the basis that the "price can only go up" and not because the physical properties themselves were worth the amount paid. The end result was a national depression and bankruptcy of previously well-respected firms like Lehman Brothers.

In these respects, the stock market can still act like a global scale Ponzi scheme. The lesson to be taken away is that no amount of news or hype can substitute for cold hard facts. A stock is a part of a company, nothing more and nothing less. Valuing as anything else can only be a recipe for disater.

References

[1] http://www.sec.gov/answers/ponzi.htm

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Obligatory Disclaimer

The author is not qualified to give financial, tax, or legal advice and disclaims any and all liability for this information.