Sunday, February 28, 2010

Ponzi and the Pyramids

We are flawed.  Those flaws result in a variety of aberrations that recur over the centuries.  Specifics may differ but the fundamentals are the same.  Greed drives certain investment schemes that are doomed  from their inception.  It is greed that enables us to overlook the clear evidence of the coming collapse.  It is also greed that motivates us to do our best to saddle someone else with the losses when the collapse does occur.

Decades ago, a friend,.  Jane*, asked my opinion of a proposal made to her.  At a gathering in Bob's home, a group of friends, acquaintances, and strangers listened to a speaker who offered them the opportunity to rapidly turn a $1000 investment into $64,000.  The speaker made it clear  that the 6400% return on investment could be theirs in a few months if they were spend a few hours each week simply sharing the good news about this investment with friends, family, co-workers, and others.

With some effort, I was able to convince Jane that the scheme was impossible.  She decided not to invest.  At least one of Jane's friends stopped speaking to her. She was frustrated that Jane would not participate. Other friends railed at her for being foolish to pass up such an opportunity.

To convince Jane that the scheme wouldn't work (for most of the participants).  I drew a graphic similar to this pyramid.

Illustration credit:  public domain, created by U.S. goverment

The pyramid shows that if each participant is able to find six new investors,  the total number of investors will soon exceed the total population of the world  Of course the number of willing investors would have been exceeded long before that.  Once no new investors can be recruited, the participants who joined in the last few levels of the pyramid all lose their money.  More than 90% of the participants will lose their money.

Jane was no math whiz, but she got the general idea. However, I was shocked to learn that among my coworkers, folks like Jim were participating. Jim has an advanced degree in engineering.  At that time he was the manager for a group of dozens of professionals.  He was responsible for budget management and profit and loss for an entire product line at a major electronics corporation.  Only God knows Jim's heart, but from what I knew of him, he was an honest man.  Yet somehow, he was helping to build the pyramid when a few simple calculations could reveal that it was doomed to failure.

I don't know if Jim  lost money.  Once a pyramid collapses, virtually none of the participants will talk about it.  The minority who actually made money fear the wrath of those who did not.  Those who lost are embarrassed by their gullibility.  There is an additional incentive to stay quiet: the entire scheme is illegal.

There are a many variants of the basic pyramid.  They have a few things in common.  Only the very earliest participants have a shot at making a profit.  New recruits are always told that they are "getting in early".  The fact that most participants will lose their money is denied, ignored, or said to be irrelevant because "we are getting in early".

Pyramid schemes are illegal.  To circumvent that difficulty, the scam is presented as a "multilevel marketing opportunity".  As with the pyramid, there an initial investment is required.  The participants are told to sell a product or service and keep a small profit from each sale.  If it stopped there, the opportunity to make money would vary depending on the skill of each new sales person, the desirability of the product or service, the size of the market and so on.  It is the multilevel aspect that should raise suspicion. In addition to selling products or services, each participant is exhorted to recruit a next level of participants who will also sell.  The person who successfully recruits some number of participants in the next level, receives either a cash bonus or a cash flow created from a small percentage of that next level's sales.  Every level is expected to recruit the members of a next level.  As with the pure pyramid, the number of participants soon swells beyond anything sustainable.
The majority of players lose their investment.  There are attempts to make multilevel marketing illegal in case where it is clear that the major incentive is recruiting new members.  However, the gray zone is large enough to house any number of such schemes. Long distance phone cards. Household products.  Dietary supplements.  Those are but a few of the items pushed in multilevel marketing.

Ponzi schemes are a variant where a small number of people benefit a lot by convincing many other folks to trust them with their money.  The return on investment offered ranges from very high to just consistently better than that available from legitimate investments.  Participants are allowed to withdraw earnings on their investment.  But the supposed earnings are simply cash extracted from new participants. Eventually the folks running the Ponzi scheme are unable to attract enough new investors to sustain the sham.  A spectacular recent example was the investment firm run by Bernie Madoff. Madoff's scam cost investors tens of billions of dollars. The phony investment firm existed for decades and brought great wealth to Madoff and a few others. The majority of investors lost all that they had invested as well as large illusory gains.

For most of us, earning money is arduous.  Saving requires discipline.  Investments entail risk.  Any offer that purports to eliminate even one of those barriers to wealth should be highly suspect.  You can bank on that.



*All names fictitious with the exception of Charles Ponzi and Bernie Madoff.
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