Ponzi-Proof Your Portfolio
A few weeks ago, a reader of this blog commented that the stock market was a Ponzi scheme. I've heard this many times in my career, and I'd like to discuss it in further detail.
Our Securities and Exchange Commission has dealt with many Ponzi schemes over the years. According to the SEC's website (http://www.sec.gov/answers/ponzi.htm):
A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.
With little or no legitimate earnings, the schemes require a consistent flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out.
The key to a successful Ponzi scheme is the gullibility of its investors. Since they never verify the underlying investments in the scheme, or the methodology used to make such stupendous returns, they are inevitably shocked when the house of cards collapses. There are no investments, no controls, no reserves, and most importantly, no ethical constraints.
How does this differ from the stock market? As an example, let's take a company like Coca-Cola. It's a public company, so it's owned by stockholders around the world. It trades on the New York Stock Exchange with the symbol "KO" for about $40 per share.
As a company, Coca-Cola has about $31 billion of net assets (factories, real estate, etc.) and earned a profit of around $8.5 billion last year. It has over 146,000 employees and sells its products in over 200 countries.
So, Coca-Cola is a very profitable company with significant real assets. We could certainly differ on how to price the company, but I think we can agree that it has substantial value. (Based on its stock price, it is currently valued at around $181 billion.)
Now, you might dislike Coca-Cola's products, or its corporate politics, or big business in general. However, my point is that there's a great difference between ownership of a tangible company via stock, and ownership of a phantom.
How do you Ponzi-proof your portfolio?
1. Ask questions. If you don't understand the answer, ask again. Rinse and repeat.
2. Don't let greed tempt you into folly. The higher a promised return, the more skeptical you should become.
3. Know what you own. If you don't understand what you own, ask. If you still don't understand, use a different investment and/or a different advisor.
As the SEC says, "[We] see too many investors who might have avoided trouble and losses if they had asked questions from the start, and verified the answers with information from independent sources." Don't fall into the trap of avarice; do your homework, carry out due diligence, and you'll have a much better chance of success.