Charles Ponzi and Bernie Madoff Would Have Been Proud of the Ponzi Schemes of 2021

Bernie Madoff, the man who ran the biggest Ponzi scheme of all time, died in jail on April 14, 2021, fifteen days shy of turning 83.

A Ponzi scheme is a fraudulent investment scheme in which older investors are paid by using money being brought in by newer ones. It keeps running until the money being brought in by the newer investors is greater than the money being paid to the older ones. Once this reverses, the scheme collapses . Or the scamster running the scheme, runs away with the money before the scheme collapses. 

The scheme is named after an Italian American, Charles Ponzi, who tried running such an investment scheme in Boston, United States, in 1920. He had promised to double investors’ money in 90 days, which meant an annual return of 1500%. At its peak, 40,000 investors had invested $15 million in Ponzi’s scheme.

Not surprisingly, the scheme collapsed in less than a year’s time, under its own weight. All Ponzi was doing was taking money from newer investors and paying off the older ones.

Once Boston Post ran a story exposing his scheme in July 1920, many investors demanded their money back and Ponzi’s Ponzi scheme simply collapsed, as money being brought in by newer investors dried up, while older investors had to be paid.

Madoff was smarter that way. His scheme gave consistent returns of around 10% per year, year on year. The fact that Madoff promised reasonable returns, helped him keep running his Ponzi scheme for decades. But when the financial crisis of 2008 struck, it became difficult for him to carry on with the pretence and the scheme collapsed.  

As I wrote in a piece for the Mint newspaper yesterday, Madoff was Ponzi’s most successful disciple ever. While Ponzi’s investment scheme started in December 1919, it collapsed in less than a year’s time in August 1920. On the other hand, documents suggest that Madoff’s scheme started sometime in the 1960s and ran for close to five decades.

Nevertheless, both Madoff and Ponzi, would have been proud of the Ponzi schemes of 2021. The only difference being that the current day Ponzi schemes are what economist Nobel Prize winning Robert Shiller calls naturally occurring Ponzi schemes and not fraudulent ones like the kind Ponzi and Madoff ran.

A conventional Ponzi scheme has a fraudulent manager at the centre of it all and the intention is to defraud investors and take the money and run before the scheme collapses. A naturally occurring Ponzi scheme is slightly different to that extent.

Shiller defines naturally occurring Ponzi schemes in his book Irrational Exuberance: 

“Ponzi schemes do arise from time to time without the contrivance of a fraudulent manager. Even if there is no manipulator fabricating false stories and deliberately deceiving investors in the aggregate stock market, tales about the market are everywhere. When prices go up a number of times, investors are rewarded sequentially by price movements in these markets just as they are in Ponzi schemes. There are still many people (indeed, the stock brokerage and mutual fund industries as a whole) who benefit from telling stories that suggest that the markets will go up further. There is no reason for these stories to be fraudulent; they need to only emphasize the positive news and give less emphasis to the negative.”

Basically, what Shiller is saying here is that the stock markets enter a phase at various points of time, where stock prices go up simply because new money keeps coming in and not because of the expectations of earnings of companies going up in the days to come.

Ultimately, stock prices should reflect a discounted value of future company earnings. But quite often that is not the case and the price goes totally out of whack, for considerably long periods of time. 

A lot of money comes in simply because the smarter investors know that newer money will keep coming in and stock prices will keep going up, and thus, stocks can be unloaded on to the newer investors. Hence, like in a Ponzi scheme, the money being brought in by the newer investors pays off the older ones. In simpler terms, this can be referred to as the greater fool theory.

The investors buying stocks at a certain point of time, when stock prices do not justify the expected future earnings, know that greater fools can be expected to invest in stocks in the time to come and to whom they can sell their stocks.

Of course, this is not the story that is sold. If you want money to keep coming into stocks, you can’t call a prospective fool a fool. There is a whole setup, from stock brokerages to mutual funds to portfolio management services to insurance companies selling investment plans, which benefit from the status quo. Their incomes depend on how well the stock market continues to do. 

They are the deep state of investment and need to keep selling stories that all is well, that stocks are not expensive, that this time is different, that a new era is here or is on its way, that stock prices will keep going up and that if you want to get rich you should invest in the stock market, to keep luring fools in and keep the legal Ponzi scheme, for the lack of a better term, going.

 — Bernie Madoff 

This is precisely what has been happening all across the world since the covid pandemic broke out. With central banks printing a humongous amount of money, interest rates are at very low levels, forcing investors to look for higher returns. A lot of this money has found its way into stock markets. The newer investors have bid stock prices up, thus benefitting the older investors. The deep state of investment has played its role.

Of course, the counterpoint to whatever I have said up until now is that unless new money comes in, how will stock prices ever go up. This is a fair point. But what needs to be understood here is that in the last one year, the total amount of money invested in stocks has turned into a flood. Take the case of foreign institutional investors investing in Indian stocks.

They net invested a total of $37.03 billion in Indian stocks in 2020-21. This was almost 23% more than what they invested in Indian stocks in the previous six years, from April 2014 to March 2020. This flood of money can be seen in stock markets all across the world.

Clearly, there is a difference, and the stock market has worked like a naturally occurring Ponzi scheme, at least over the last one year.

This Ponziness is not just limited to stocks. Take a look at what is happening to Indian startups…oh pardon me…we don’t call them startups anymore, we call them unicorns, these days. A unicorn is a startup which has a valuation of greater than billion dollars.

How can a startup have a valuation of more than a billion dollars, is a question well worth asking. I try and answer this question in a piece I have written in today’s edition of the Mint newspaper.

As mentioned earlier, there is too much money floating all around the world, particularly in the rich world, looking for higher returns. Venture capitalists (VCs) have access to this money and thus are picking up stakes in Indian startups at extremely high prices.

Many of these startups have revenues of a few lakhs and losses running into hundreds or thousands of crore. The losses are funded out of money invested by VCs into these unicorns.

The losses are primarily on account of selling, the service or the good that the startup is offering, at a discounted price. The idea is to show that a monopoly (or a duopoly, if there is more than one player in the same line of business) is being built in that line of business and then cash in on that through a very expensive initial public offering (IPO).

As and when, the IPO happens, a newer set of investors, including retail investors, buy into the business, at a very high price, in the hope that the company will make lots of money in the days to come. Interestingly, IPOs which used to help entrepreneurs raise capital to expand businesses, now have become exit options for VCs. 

If an IPO is not possible, then the VC hopes to unload the stake on to another VC or a company and get out of the business.

In that sense, the hope is that a newer set of investors will pay off an older set, like is the case in any Ponzi scheme. Of course, this newer set then needs another newer set to keep the Ponzi going.

The good thing is that when investors buy a stock of an existing company or in a new company’s IPO, they are at least buying a part of an underlying business. In case of existing companies, chances are that the business is profitable. In case of an IPO, the business may already be profitable or is expected to be profitable.

But the same cannot be said about many digital assets that are being frantically bought and sold these days. There is no underlying business or asset, for which money is being paid. Take the case of Dogecoin which was created as a satire on cryptocurrencies.

As I write this, it has given a return of 24% in the last 24 hours. An Indian fixed deposit investor will take more than four years to earn that kind of return and that too if he doesn’t pay any tax on the interest earned.

Why is Dogecoin delivering such fantastic returns? As James Surowiecki writes in a column: “There is no good answer to that question, other than to say Dogecoins have gotten dramatically more valuable because people have decided to act as if they’re more valuable.”

As John Maynard Keynes puts it, investors are currently anticipating “what average opinion expects the average opinion to be.” Carried away by the high returns on Dogecoin, the expectation is that newer investors will keep investing in it and hence, prices will keep going up. The newer investors will keep paying the older ones. That is the hope, like is the case with any Ponzi scheme, except for the fact that in this case, there is no fraudulent manager at the centre of it all.

Of course, the only way the value of Dogecoin and many other cryptocurrencies can be sustained, is if newer investors keep coming in and at the same time, people who already own these cryptocurrencies don’t rush out all at once to cash in on their gains.

If this does not happen, as is the case with any Ponzi scheme, when existing investors demand their money back and not enough newer investors are coming in, this Ponzi scheme will also collapse.

– Charles Ponzi 

Given this, like is the case with people who are heavily invested in stocks, it is important for people who are heavily invested in cryptos to keep defending them. Of course, a lot of times this is technical mumbo jumbo, which basically amounts to that old phrase, this time is different.

But this time is different is probably the oldest lie in finance. It rarely is.

And if dogecoin was not enough, we now have investors going crazy about non-fungible tokens (NFTs), which in simple terms is basically certified digital art. As Jazmin Goodwin points out: “For example, Jack Dorsey’s first tweet is now bidding for $2.5 million, a video clip of a LeBron James slam dunk sold for over $200,000 and a decade-old “Nyan Cat” GIF went for $600,000.” The auction house Christie sold its first ever NFT artwork for $69 million, in March.

In a world of extremely low interest rates and massive amount of printing carried out by central banks, there is too much money going around chasing returns.

There aren’t enough avenues and which is why we have financial and digital assets now turning into naturally occurring Ponzi schemes, giving the kind of returns that the original Ponzi scamsters, like Ponzi himself and his disciple Madoff, would be proud off.

Madoff’s scheme delivered returns of 10% returns per year. Ponzi promised to double investors’ money in three months or a return of 100% over three months. As I write this, Dogecoin has given a return of more than 600% over the last one month.

Here’s is how the price chart of Dogecoin looks like over the last one month.

Source: https://www.coindesk.com/price/dogecoin.

 

Sensex @28,500 : Stock Market as a beauty contest

bullfightingVivek Kaul

We never know what we are talking about – Karl Popper

The Sensex closed at 28,499.54 points yesterday (i.e. November 24, 2014). The fund managers are confident that this bull run will last for a while. Or so they said in a round table organised by The Economic Times.
Prashant Jain of HDFC Mutual Fund explained that during the last three bull markets that India had seen, the market had never peaked before reaching a price to earnings ratio of 25 times. The price to earnings ratio currently is 16 times, and hence, we are still at a “reasonable distance” from the peak.
This seems like a fair point. But how many people invest in the stock market on the basis of where the price to earnings ratio is at any point of time? If that were the case most people would have invested in 2008-2009, when the price to earnings ratio of the Sensex
through the year stood at 12.68.
By buying stocks at a lower price to earnings ratio, they would have made more money once the stock market started to recover. But stock markets and rationality don’t always go together. Every investor is does not look at fundamentals before investing. “In investing, fundamentals are the underlying realities of business, in terms of sales, costs and profits,” explains John Lanchester in How to Speak Money.
A big bunch of stock market investors like to move with the herd. Let’s call such investors non fundamentals investors.
So when do these investors actually invest in the stock market? In order to understand this we will have to go back to John Maynard Keynes. Keynes equated the stock market to a “beauty contest” which was fairly common during his day.
As Lanchester writes “Keynes gave a famous description of what this kind of non-fundamentals investor does: he is looking at a photo of six girls and trying to pick, not which girl he thinks is the prettiest, and not which he thinks most people will think is the prettiest, but which most people will think most people will think is the prettiest…In other words the non-fundamentals investor isn’t trying to work out what companies he should invest in, or what company most investors will think they should invest in, but which company most investors will think most investors will want to invest in.”
Or as Keynes put it in his magnum opus
The General Theory of Employment, Interest and Money“It is not a case of choosing those [faces] that, to the best of one’s judgement, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
Hence, a large bunch of investors invest on the basis of whether others round them have been investing. That is the beauty contest of today.
Nilesh Shah, MD and CEO of Axis Capital pointed out in
The Economic Times round table that nearly Rs 25,000-Rs 30,000 crore of money will come into the stock market through systematic investment plans (SIPs).
Anyone who understands the basics of how SIPs work knows that they are designed to exploit the volatility of the stock market—buy more mutual fund units when the stock market is falling and buy fewer units while it is going up. This helps in averaging the cost of purchase over a period of time, and ensures reasonable returns.
Investors who are getting into SIPs now are not best placed to exploit the SIP design. Nevertheless, they are still investing simply because others around them have been investing. This also explains why the net inflow into equity mutual funds for the first seven months of the this financial year (between April and October 2014) has been at Rs 39,217 crore. This is when the stock market is regularly touching new highs.
And if things go on as they currently are, the year might see the
highest inflow into equity mutual funds ever. The year 2007-2008 had seen Rs 40,782 crore being invested into equity mutual funds. This was the year when the stock market was on fire. In early January 2008, the Sensex almost touched 21,000 points. It had started the financial year at around 12,500 points.
So, now its all about the flow or what Keynes said “what average opinion expects the average opinion to be.” And till people see others around them investing in the stock market they will continue to do so. This will happen till the stock market continues to rise. And stock market will continue to rise till foreign investors
keep bringing money into India.
No self respecting fund manager can admit to the fact that these are the reasons behind the stock market rallying continuously all through this year. This is simply because all fund managers charge a certain percentage of the money they manage as a management fee.
And how will they justify that management fee, if the stock market is going up simply because it is going up. Nobel prize winning economist Robert Shiller calls such a situation a naturally occurring Ponzi scheme.
As he writes in the first edition of
Irrational Exuberance: “Ponzi schemes do arise from time to time without the contrivance of a fraudulent manager. Even if there is no manipulator fabricating false stories and deliberately deceiving investors in the aggregate stock market, tales about the market are everywhere. When prices go up a number of times, investors are rewarded sequentially by price movements in these markets just as they are in Ponzi schemes. There are still many people (indeed, the stock brokerage and mutual fund industries as a whole) who benefit from telling stories that suggest that the markets will go up further. There is no reason for these stories to be fraudulent; they need to only emphasize the positive news and give less emphasis to the negative.”
And that is precisely what fund managers will do in the time to come. In fact, they have already started to do that.
They will tell us stories. One favourite story that they like to offer is that India’s economy is much better placed than a lot of other emerging markets. This is true, but then what does that really tell us? (For a
real picture of the Indian economy check out this piece by Swaminathan Aiyar).
Another favourite line you will hear over and over again is that “markets are never wrong”. This phrase can justify anything.
The trick here is to say things with confidence. And that is something some of these fund managers excel at. Nevertheless it is worth remembering what Nassim Nicholas Taleb writes in
The Black Swan: “Humans will believe anything you say provided you do not exhibit the smallest shadow of diffidence; like animals, they can detect the smallest crack in your confidence before you express it. The trick is to be smooth as possible in personal manners…It is not what you are telling people, it how you are saying it.”
And this is something worth thinking about.

The article originally appeared on www.equitymaster.com on Nov 25, 2014

The case against equity investing: In the long run we are all dead


Vivek Kaul

Stocks are for the long run is a phrase you would have heard often. But that’s not what William H Gross seems to believe anymore. “The cult of equity is dying. Like a once bright green aspen turning to subtle shades of yellow then red in the Colorado fall, investors’ impressions of “stocks for the long run” or any run have mellowed as well,” he wrote in his monthly investment outlook for August 2012.
Gross is the Managing Director of Pacific Investment Management Company (Pimco) and manages Pimco’s Total Return Fund. The Total Return Fund currently has assets under management of $263billion and is the biggest mutual fund in the world.
“An investor can periodically compare the return of stocks for the past 10, 20 and 30 years, and find that long-term Treasury bonds have been the higher returning and obviously “safer” investment than a diversified portfolio of equities,” wrote Gross. So what this clearly tells us is that the higher risk of investing in stocks is not always rewarded with excess return and sometimes it might just make sense to invest in dull and boring bonds which guarantee a given rate of return.
But that’s just one part of the evidence. In the really really long term stocks have done very well. As Gross points out “The long-term history of inflation adjusted returns from stocks shows a persistent but recently fading 6.6% real return (known as the Siegel constant) since 1912.” Hence $1 invested in 1912 would have turned to $500(inflation adjusted) hundred years later i.e. now in 2012. No wonder the Americans took onto investing in stocks like nobody else did. The prime reason for this was the premise that returns from equity beat that from bonds over the long run. Shankar Sharma, joint managing director and vice chairman of First Global explained this phenomenon to me in a recent interview I did for the Daily News and Analysis (DNA) in this way: “Rightly or wrongly, they (the Americans and the much of the Western world) have been given a lifestyle which was not sustainable, as we now know. But for the period it sustained it kind of bred a certain amount of risk taking because life was very secure. The economy was doing well. You had two cars in the garage. You had two cute little kids in the lawn. Good community life. Lot of eating places. You were bred to believe that life is going to be good so hence hey, take some risk with your capital. People were forced to invest in equities under the pretext that equities will beat bonds… They did for a while. Nevertheless, if you go back thirty years to 1982, when the last bull market in stocks started in the United States and look at returns since then, bonds have beaten equities. But who does all this Math?” (You can read the complete interview here)
What has changed now is the ability of Americans to take risk by investing in equity. “Americans are naturally more gullible to hype. But now western investors and individuals are now going to think like us. Last ten years have been bad for them and the next ten years look even worse. Their appetite for risk has further diminished because their picket fences, their houses all got mortgaged. Now they know that it was not an American dream, it was an American nightmare. So I cannot make a case for a broad bull market emerging anytime soon,” said Sharma.
And this seems phenomenon seems to be clearly evident in the numbers that are coming out. As the USA Today reported in mid May: “Stocks remain out of fashion…Retail investors have yanked more than $260 billion out of mutual funds that invest in US stocks since the end of 2008, says the Investment Company Institute, a fund trade group. In contrast, they have funneled more than $800 billion into funds that invest in less-volatile bonds. Investors’ chronic mistrust of stocks is reigniting fears that an entire generation is unlikely to stash large chunks of cash in the increasingly unpredictable market as they did in the past. “Investors have suffered a traumatic shock that has caused severe psychological damage and made them more risk-averse,” says Carmine Grigoli, chief investment strategist at Mizuho Securities USA.”
The phrase to mark here is “risk-averse”. As Sharma puts it “Investing in equity is a mindset. That when I am secure, I have got good visibility of my future, be it employment or business or taxes, when all those things are set, then I say okay, now I can take some risk in life.”
The question that concerns us in India is how will this change in mindset impact India? Before I come to that question let me deviate a little and discuss the concept of naturally occurring ponzi schemes.
A ponzi scheme essentially is a fraudulent investment scheme in which money being brought in by new investors is used to pay off the old investors. The people running the scheme typically promise very high returns to tempt prospective investors to invest money in the scheme. But this money is not invested anywhere to generate returns. The “promise” of high returns ensures that newer investors keep coming in. They money they bring in is used to pay off the older investors. The scheme keeps running till the money being brought in by the new investors is lesser than the money that needs to be paid off to the older ones. This is the point when the scheme collapses. Typically the people who run such schemes disappear with the money, before the scheme collapses.
In his book, Irrational Exuberance, Robert Schiller introduces the concept of Naturally Occurring Ponzi Schemes, which happen without the contrivance of a fraudulent manager. Such a scheme works on a price to price feedback theory. When prices go up creating successes for some investors, this may attract public attention, promote word of mouth enthusiasm and heighten expectations for further price increases. (Adapted from Shiller 2003). The stock market is the best example. Stories about stock markets going up spread very fast. Investors, in an optimistic mood, might want to buy stock and take the stock price further up. This leads to more investors entering the market, fuelling an even greater price rise and the cycle gets repeated over and over. As Shiller mentions, “When prices go up a number of times, investors are rewarded by price movements in these markets, just as they are in Ponzi Schemes.”
The point being that the real returns in the stock market are made when prospective investors are in the Ponzi scheme mode and are willing to invest. A major reason for the bull run in the stock market in India between 2003 and 2007 was the fact that foreign investors brought in a lot of money, thus driving up stock prices and generating returns for those who had already invested. But things have changed over the last five years.
Between April 2007 and July 2012, the foreign investors invested Rs 3,538,108.46 crore in Indian stocks. That clearly is a lot of money. But they also sold Rs 3,537,016.97 crore worth of Indian stocks. This means that the net investment of foreign investors in Indian stocks in the last five years and three months has been a miniscule Rs 1091.49crore.
During the same period the domestic institutional investors made investments worth Rs 1,571,084.73 crore. They sold stocks worth Rs 1,462,118.66 crore. Hence their net investment in stocks was Rs 108,938.27 crore. (Source: www.moneycontrol.com)
It is this net investment by Indian institutional investors which ensured that the BSE Sensex, India’s premier stock market index, has delivered an absolute return of 30% since April 2007. This means an average return of 5.1% per year. I need not tell you that you would have been better off doing a fixed deposit where the returns were more or less guaranteed. If you had taken on some risk by investing in a mutual fund scheme like Birla Sun Life MIP-II Savings 5 G, you would have managed to get a return of 10.35% per year, more than double that of the stock marekt. The scheme invests 95% of the money collected in debt and the remaining in stocks.
The point I am trying to make is that for the stock market in India to give good returns it is important that foreign investors bring money into India and stay invested in Indian stocks. With their attitudes towards investing in stocks changing whether they will continue to invest in India, remains to be seen.
The other way out is that Indian investors start investing more money in the stock market both directly and indirectly. I don’t see that happening due to two reasons. A lot of Indian investors over the last few years invested money in the Indian stock market indirectly through unit linked insurance plans(Ulips) sold (or rather mis-sold) by insurance companies.
They are now coming to the realization that they have been taken to the cleaners. Money invested five to seven years back is just about breaking even and they would have been much better off by simply letting their money lie idle in a savings bank account.
This is primarily because Ulips used the premium paid by investors to pay very high commissions to insurance agents and did not invest the full premium. So these investors who were taken for a royal ride are not going to come back to the stock market anytime soon.
While systematic investment plans( SIPs) offered by mutual funds have done a lot better than Ulips but the returns are nowhere in the region that would compensate for the increased risk of investing in stocks.
The other reason is a more fundamental reason that was explained to me by Shankar Sharma. “Emerging market investors are more risk averse than the developed world investors. We see too much of risk in our day to day lives and so we want security when it comes to our financial investing… But look across emerging markets, look at Brazil’s history, look at Russia’s history, look at India’s history, look at China’s history, do you think citizens of any of these countries can say I have had a great time for years now? That life has been nice and peaceful? I have a good house with a good job with two kids playing in the lawn with a picket fence? Sorry boss, this has never happened…. Indians have figured out that equities are a fashionable thing meant for the Nariman Points of the world.”
Given these reasons it is difficult to make a case for equities as a long term investment in India as well, though things may not turn to be as bad as they might turn out to be in America and other parts of the Western world.
In the end let me quote an economist who the world always goes back to, when they run out of everything else. As John Maynard Keynes once famously said “In the long run we are all dead”.
(The article originally appeared on www.firstpost.com on August 6,2012. http://www.firstpost.com/investing/the-case-against-equity-in-the-long-run-we-are-all-dead-406223.html)
(Disclosure: Despite the slightly negative take here, the writer continues to makes regular investments in the Indian stock market through systematic investment plans, though the amount of investments have come down over the last six months)
(Vivek Kaul is a writer and can be reached at [email protected])