Investor Facts: What Is A Ponzi Scheme?

When investments flame out and fall to zero they often are referred to as being akin to a “Ponzi scheme.” While there may be a number of reasons a stock or mutual fund can fail, the comparison is broadly inaccurate.

The phrase Ponzi scheme dates back to an actual person named Charles Ponzi. The 19th century Italian swindler preyed on gullible investors in the United States and Canada, offering extremely high returns in exchange for nominal upfront investments.

Rather than invest the cash Ponzi instead used the money to pay previous investors, seeking out new suckers until the inevitable collapse.

Mugshot of Charles Ponzi (Source: Smithsonian Magazine)

The Bernie Madoff scandal, which ran into the tens of billions of dollars and thousands of investors, worked the same way — so long as the number of investors grew, original investors made high, steady gains despite the lack of an actual underlying investment to drive that growth.

Yes, stocks go up because investor demand is greater than supply. However, stocks also go down if investors no longer believe the company’s prospects for growth are real. That’s why stocks that trade on major stock exchanges are heavily regulated and must regularly report accurate earnings.

If earnings decline, or if the reporting is suspect, investors rightly punish the stock by selling it. That selling action can sometimes lead to further declines in the stock’s valuation, at least until investors believe the price is so low as to represent a bargain.

In the end, however, the main reason investors buy a stock is because they believe that the earnings of the underlying company are going to rise in the future.

As part owners of the company, those investors also enjoy rights to income from the stock in the form of a dividend.

While a young company’s growth is fast those dividends are likely to be reinvested. Once a company gets larger and has maximized its market presence, chances increase that earnings instead will be distributed as dividend income to investors. The more shares you control, the more income you get.

Growth from the economy

In general, companies seek to increase earnings by a rate greater than the risk-free rate from owning U.S. Treasury bonds. Otherwise, why take the risk of owning the stock?

As personal income in an economy grows, usually from wage growth, population growth or both, that income is distributed to companies by economic means — increasing sales of goods and services, such as new cars, daily cups of coffee, movie tickets, etc.

Any company that garners a commanding share of spending is going to attract investors. Demand for shares causes the value of the company’s stock to rise over time.

It certainly doesn’t hurt that new investors are interested in the stock, but the stock price is not dependent on increasing number of new investors in order to pay previous investors.

If that were true, many of the large and well-established companies in  the economy should see their valuations fall to zero, which doesn’t happen unless the management is exposed for some kind of wide-ranging fraud.

MarketRiders, Inc. is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.