## Saturday, October 19, 2013

### Is the Stock Market a Ponzi Scheme?

Today I want to explore the question on whether or not the Stock Market is a Ponzi scheme. The reason why is that I think many people view it as such but may not even realize it. So the big question here is this: are they right?

#### Charles Ponzi's Scheme

Charles Ponzi came up with an ingenious way to make money. He would (or so he claimed) invest in international reply coupons (IRCs). These allowed people to reply to a correspondence by trading in the coupon for a local stamp to ship a reply letter. Given that there were two markets for these, there was potential for an arbitrage (an arbitrage is a just a fancy way of saying paying a low price in one market and then turning around and selling the same or similar item in another market for a higher price, profiting the difference.)

But Charles Ponzi's "scheme" was more about taking investors money than profiting from IRCs. Since most investors simply reinvested their "profits", he only had to pay a portion of the profits. So when he received investment money from new investors, that investment money would pay off the old investors.

Needless to say, as soon as the flow of new investors stops (or merely slows down) the scheme falls apart.

#### The Stock Market: One Giant Ponzi Scheme?

So is the stock market like this Ponzi scheme? If you were to ask someone uninformed on how stocks work, you might draw that conclusion. Imagine the following conversation.

Samuel Goti: So you're investing in the stock market?

Joe: Well, of course I am. I need to save for retirement.

Sam: So how does that work? How does that make you money?

Joe: Well, I go buy some stocks and if the companies do well, they go up in price.

Sam: But what does that mean? - they go up in price?

Joe: Well, yeah. So I buy shares of XYZ for $\$25$and they go up to$ \$50$. So I doubled my money.

Sam: So you sell them then.

Joe: Well, sometimes. But sometimes I hope they go up more so I hold on to them.

Sam: And when you sell them, someone else buys them?

Joe: That's right.

Sam: So you profit from the sale of XYZ because someone else comes along and buys the same stock from you for a higher price. Is that how that works?

Joe: I suppose someone else would have to be paying the $\$50 $. Sam: So why would they pay$ \$50$ for your stock?

Joe: Well, I guess they expect the stock to go up.

Sam: . . . and by "go up", you mean someone else would be willing to pay a still higher price?

Joe: I guess it has to be that way.

Sam: So would this continue on forever? You buy a stock expecting someone else to pay a higher price. And that individual does so because he expects someone else to pay a still higher price. Is that what you mean?

Joe: Well, I guess it would have to . . .
At this point Joe is thinking here because there's a bit of conundrum here. What he's essentially described is a Ponzi Scheme. New investors are required to put up more money to pay for the profits of the previous investors. That sounds like a Ponzi scheme...
Joe: Well, what about corporate profits? Don't profits make stocks go up?

Sam: Well, how does that work?

Joe: Well, I would pay a lot of money for a company that makes a lot of profits.

Sam: OK. So how do you make money from that?

Joe: Well, the company makes a lot of profits and the stock goes up so I can sell it for a higher price.

Sam: Why would someone be willing to pay a higher price?
At this point Joe realizes that we're going to end up down the same road again. Sure, now we've given the new buyer a reason (higher profits) to pay a higher price but that still doesn't tell us how to make money this way. It still sounds a lot like our previous Ponzi Scheme but now we have this reason for being willing to pay a higher price.
Joe: What if the company pays you its profits?

Sam: So how does that work?

Joe: Well, the stock can pay a portion of its profits to its shareholders. In fact, they have a name for that. I think they call it a "dividend".

Sam: Oh. So you profit from it because the company pays you these dividends. And these dividends ultimately justify the price you paid?

Joe: That's right. Because if the company pays me more in dividends than I paid for the stock, I make a nice profit that way.

And that's how the stock market is not a Ponzi Scheme!

#### Final Thoughts

While this is just fictitious conversation, I think many people think about stocks in this way (assuming they think about stocks at all). In fact, it would be interesting to do a study to see how many do think of stocks this way.

In any event, my main point here is that the stock market isn't a Ponzi Scheme even if it may seem that way. What makes a stock worth buying is that it will (hopefully) pay dividends over the course of its life. It's important to keep that in the back of one's mind as that's the true value of the stock.

I would contend that thought should, to some extent, guide your investment decisions. And at least in Keynes sense, to do otherwise is speculation, not investment.

1. your explanation needs a lot of work. by your explanation a stock that has no intention of ever paying a dividend would be a ponzi scheme, which is not correct (in fact there are large #s of other examples whereby the only exit strategy *is* price appreciation, but yet are in no way ponzi schemes). A ponzi scheme generally has several features which distinguish it 1) misappropriation of investor funds, iow raising capital w/the stated intention of using the capital to generate a profit but instead not using the money for this purpose and not informing investors 2) a lack not only of a legitimate profit/value-generating business (which is not illegal because many businesses try to be profitable and fail), but conveying to investors that such a business does exist when it actually does not. To get the deception past investors, a ponzi scheme usually promises to pay out a much higher than normal interest rate than can be gotten elsewhere in the market. This last part on it's own is not necessarily illegal, but it can be an indicator for an investor to look closely at 1 and 2. Likewise extremely smooth always positive returns are also characteristic of ponzi schemes and can cause an investor to look for 1 and 2.

2. Hi Joshua, thanks for the reply.

What I'm doing is relying on a sort of metaphor. Metaphors tend to be similar in certain respects but break down in others. I'm focusing on one essential feature of ponzi schemes: new investors paying for the profits of older investors.

You're certainly correct to point out that having that feature, while necessary, is not sufficient in a legal sense. But even in a non-legal sense I think one could argue that there ought to be a deception involved.

I'm primarily focused on what the "investment" looks like from the investor's perspective. I believe a lot of people have some goofy beliefs about what the stock market is or what counts as an "investment" ("something that goes up in price") that I believe are erroneous. So I think I can sort of make the case that there is a "deception" going on in some cases, but it's not coming from the entities issuing and underwriting the securities but the investor deceiving him/herself about the asset.

Now I am curious about what sort of examples you had in mind.

One example you provide is that of a company that just fails to generate adequate profits even though they had intended to do so. There I would probably just call it a "bad investment" and not a "ponzi scheme".

One example that came to my mind were inverse ETNs which are basically bonds that pay no coupons and have a principal tied to an index that will likely decline in value over time. There's certainly no deception on the part of the issuing entities since the details are spelled out in the prospectus (that everyone reads). I don't know I'd even consider these as investments.

Consider this last example. I'm issuing shares in an investment company. By buying shares in my company, you don't get any voter rights and there will never be any dividend payments. What would you think of such a thing? Does it actually matter what I'd do with the money (I'd probably invest it all)?

What examples do you have in mind?

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6. Thanks for the simple explanation - have always thought there were some similarities, but never thought it through till now. I agree with Joshua that the key difference is the lack of deception about where the money goes when stocks are bought - either during an IPO or in the open market. You ask - does the lack of deception really matter? For me the answer is clearer with a better (if heavily overused) metaphor which is that a stock market is like a casino (at least for stocks without dividends). The rules of casino games are known to all ahead of time and no deception is necessary to get people to play. Also, like purely speculative (non-dividend) stock trading, casino games are zero-sum. Your winnings always come out of somebody else's pocket. One key feature that I think makes stock markets better for society than casinos is that stock markets directly benefit real world companies by allowing them to get millions or billions of dollars in cash essentially for free during IPOs and secondary stock offerings. For example, in May 2013, Tesla took in millions of dollars from a secondary stock sale - which allowed it to repay loans and probably funded more R&D and infrastructure. Because of this, I think the fewer dividend-paying stocks there are the better, since dividends take money out of companies which might otherwise have put it to productive use, and give it to individuals who are often not working for the company and so did nothing to earn this money.

1. @Ben Weisburd

I think the main difference between the casino and the stock market is that the latter is considered an investment class while the former is not. So if the stock market was zero-sum (per your scenario) then it would fail to be an investment class. That would be the potential "deception" if you will.

And the fact that the stock market isn't zero-sum is one of the reasons I don't like when investors use that metaphor.

Regarding the latter point about giving money to people that didn't earn it, isn't that what capitalism is all about? :)

7. Hmm.. can you explain how the stock market is not zero sum (other than the dividends)?

Re: "isn't that what capitalism is all about?"
As someone who grew up in the former Soviet Union, I can assure you that it unquestionably is.

8. Sorry, I worded that poorly.

If there were no dividends, then the analogy would apply.

I think there are plenty of interesting questions regarding the role of the rentier class in society. I'm taking that as entirely given.

I've wondered to what extent a different class of shares might emerge where the primary goal isn't to increase shareholder wealth. Perhaps they could shoot for BBB yields as far as returns go and then focus on various other goals.

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