Brace for armchair economics and philosophy. Please ensure your seat belt is securely fastened.
Summary: The answer is no, shares lack the defining feature of ponzi schemes. However, for the many shares that lack worthwhile dividends, they have some features in common with baseball cards and other collectibles: namely such shares have no value besides their sentimental value and what another collector is willing to pay you.
Madoff's Ponzi Scheme: Seeing a newspaper today at a climbing weekend in Montague, I read about Bernard Madoff, who was arrested in December 2008, and whose hedge fund has been declared the largest one-man Ponzi Scheme in history (aka Pyramid Scheme). He would take in investors money, and used it to pay out the earlier investors who cashed out, keeping the rest to himself. $50 billion evaporated when the scheme was exposed because too many people pulled out during the 2008 crash to pay them all out. Madoff spent the time enjoying life, dabbling in markets, and fooling blinded-by-greed investors and the Securities and Exchange Commission. Sucks to be you, investor.
Stock Market == Ponzi Scheme? Doesn't the stock market work similarly? Very few companies pay substantial dividends, preferring to push their share price up by reinvesting. Without dividends, all of the money payed out to earlier investors is coming from the new investors paying in... just like a Ponzi scheme. An increase in share price does not magically create money - that is instead the sacred duty of the government and fractional reserve banking. I googled the Stock Market == Ponzi Scheme idea and found this article by Dan Goldstein on The Stock Market as a Ponzi Scheme.
Now to evaluate some evidence...
1. Do shares give you ownership? Dan discusses the point that shares give you part ownership of the company, while Ponzi schemes only give you a promise of being paid out with too-good-to-be-true profits. But when you don't have a seat on the board, and the CEO won't take your calls... you don't have any measurable influence on the company, and therefore no ownership that counts. To get meaningful ownership rights, start saving for a 5% stake in the company.
2. Robbing Peter to pay Paul. When the market crashed last year, it was solely due to the credit crunch: more investors wanted to sell out, but there was a lack of incoming money (and credit), thus fewer buyers, pushing prices down. It had nothing to do with the economic value of the everyday widget-making companies whose share prices dropped 30-50%. Then again, the same applied to housing prices.
3. Baseball cards vs Ponzi Scheme Shares lacking dividends are much like baseball cards - no value other than the willingness of someone else to buy them off you. But baseball cards are not Ponzi schemes.
Compare baseball cards to the Madoff fund. Investors bought units from Madoff, and sold them back to Madoff later for profit. What made Madoff's fund a Ponzi scheme is that Madoff was pretending to give out profit to lure more investors. In reality he was paying earlier investors out of the incoming money, and doing what he pleased with the remainder. A real hedge fund can liquidate and pay out all of its investors at the stated unit price. Madoff's fund could not because it wasn't making any profit, the fact which eventually exposed the scam.
But baseball cards and shares do not have a Ponzi structure - they are just an asset whose value is "all in the mind". Unlike Madoff's "Ponzi fund", there is no central entity controlling all shares in Company X who could pass money from buyers to sellers and do what he pleases with the leftovers, so long as there are more buyers than sellers. I conlude that stocks are not Ponzi schemes, because of vital structural difference: investors trade shares as if they were cards, not as if they were buying units in a mutual fund.
4. A side-note Economic Value: Arriving at armchair philosophy, economic value is solely a human phenomenon, having no existence outside of the minds of humans, much like God (self-link re Douglas Adams' "Is there an artifical God?" speech), or Right and Wrong (the Universe doesn't care, but people do). Nonetheless, so long as economic value is being created there will be more buyers into stocks, and it survives. If value starts being destroyed faster than it is created, the all-share index would decline, but it wouldn't necessarily collapse like a Ponzi scheme.
So the stock market isn't a Ponzi scheme, but the two have enough shared characteristics to confuse me for a while.
6 comments:
My response to your post got a little long, and ended up as a blog post of its own :)
I'm not sure you can ask this sort of question without considering the efficient market hypothesis. Perhaps a better question to ask (one without the negative connotations of a "Ponzi scheme") would be "Can I beat the market"?
Because knowing that the market is a Ponzi scheme must surely give you information that you can use to make money.
I don't think that's the case. In some sense you are suggesting that stock prices are not based on fundamentals. It may not be that the new information that came with the credit crunch implied that future profits will be lower and caused a price correction, but you should at least consider it.
I look forward to hearing which stocks you are shorting... ;-)
Hey guys, I've substantially edited the post.
A stock without dividends is not quite right, basically a baseball card, but not really a ponzi scheme because of the lack of a central person participating in all the trades who can fool buyers and sellers.
The problem with the baseball card analogy is that the assumption with cards is that some collector out there wants the card itself. There's an endgame: the highest bidder takes the card and keeps it forever (or until s/he dies) just because s/he wants to keep the card in his or her collection. Besides this, as the years go on the card becomes more and more rare as others like it get lost, torn, burned, et cetera. So when the cardholder dies, and the card moves on, there is a great likelihood that another collector out there wants the card, not to sell it for profit, but to OWN it. There's no end game with stocks. Stocks don't burn or get water damage. Their numbers only increase. I don't want them because they're rare and will look god in my collection. I only want them so I can sell them to the next guy, at a profit, and the next guy only wants them so he can do the same... so what happens when we run out of "next guys"? It's this question that makes the market more like a Ponzi scheme than a baseball card collection.
The defining feature of a ponzi scheme is the person in the middle who pays people out of the money coming into the scheme. So long as money coming in is more than the money he has to pay out + the conmans cut, the scheme stays afloat.
I'm comparing baseball cards to share certificates for companies with low or zero Dividend Payout Ratio ratio. The features in common are that the monetary value is what another collector will pay for it (no money-generation value) and I suppose both have sentimental value (many investors are as sentimental about their stocks as collectors are about their baseball cards). Both cards and shares as assets also have no practical use (unlike say a house or a car).
Also the Dividend Yield, which is annual dividend income per share divided by the current share price.
And of course the baseball card analogy doesn't hold on all points. For example, paper share certificates (no obsolete) do not have pictures of baseball players on the front.
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