The Lure of Ponzi Schemes

by Manshu on May 19, 2009

in Economy

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Image by Timothy Valentine

I came across this IMF working paper on Ponzi schemes via the Baselinescenario and it has got some pretty interesting facts about them.

What caught my eye was that most investors get sucked into Ponzi schemes, even when there are plenty of signs that the scheme is too good to be true, and it reminded me of the way things were during the dot com boom.

Too Good To Be True

Most of the bigger scams mentioned in the paper promised monthly returns that should raise your eyebrows, even if someone was offering them annually. Most investors know that such numbers are impossible to attain over a long period, but, somehow they manage to convince themselves that everything is just fine.

The opacity of the schemes should be the second indicator that something is wrong, but, investors are generally happy to leave the boring details to their fund managers and so aren’t surprised that the fund doesn’t even have a prospectus.

Great PR

A lot of people get conned in Ponzi schemes and they are not necessarily foolish or greedy. There is a lot of public relations (PR) work that goes on to make a Ponzi scheme tick. It is not easy to ignore such great PR; not to mention the wealth your neighbor is amassing in the same scheme. That’s just human nature.

Ponzi PR

Often, Ponzi Schemes are carried out by very influential people who are politically well connected and on top of that donate to charity quite liberally. This gives them the soft power and the aura to attract investors and create a sort of halo, which says — they could do no wrong.

Donating millions to charities, political parties and churches help them win friends who can pass on their credibility to the Ponzi scheme and help it run a little longer. So even when officials warn that there is something wrong with the scheme, there is a backlash from prominent figures and that acts as a powerful shield for the Ponzi Scheme.

The other factor that lures people is that someone they know is making money out of the scheme. This is a very significant factor and I think ultimately this is what tips the scales in favor of the Ponzi scheme.

Parallels with the Dot Com Boom

During the dot com boom, there were many Indian cement, retail and even fertilizer companies that changed their names to make them sound like an IT Company. Suddenly — Acme Cements turned into Acme Infosystems. Soon thereafter these companies went for an IPO which got heavily oversubscribed and popular.

At that time I was quite surprised to see that the people who invested in such IPOs knew that they were not buying an IT company, but were not bothered by the fact that a cement company is trying to fool people into thinking that it exports software.

There were several reasons people did that and I think it has some strong parallels with people investing in Ponzi Schemes.

1. Others were making money: At that time almost every IPO made money and over a period of a couple of years, it became a sure shot way of making money in the market. A ponzi scheme will give handsome returns to investors till the time it is discovered. In that sense people are lured to it by seeing that someone they know has already made quite a bit of money on them.

2. Analyst Support: Equity analysts who were supposed to know better came on television and recommended the IPOs. So, analysts with brokerages that had offices all over the world lend credibility to these companies.

3. Any Publicity is Good Publicity: A lot of these companies got negative publicity from the press about changing names, but at the same time there was no action from the regulators because they were not doing anything illegal. This made people think that if the government is not taking any action despite all the negative press, everything must be alright. The same is true for Ponzi schemes too; regulators need data and evidence to take any action, but this is usually a long drawn process. In the meantime people tend to get attracted towards the Ponzi schemes precisely because — no action is being taken.

Conclusion

People are wired in a way that makes them susceptible to following the herd in booms, falling for Ponzi schemes and the like. It’s good to recognize the things that make us fallible and watch out for them. There is really no better way to protect your money than by using common sense and looking for honest people to do business with.

{ 1 comment… read it below or add one }

ctreit May 21, 2009 at 6:40 pm

I find it amazing that humans keep falling for such schemes, and not only these. There are so many funny (and irrational) behaviors around money that an entire branch of economics developed around it – behavioral finance.

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