Is the stock market a ponzi scheme?

While writing a blog post on that poisoned chalice of a topic – HIV and nutrition, I came across a post by Graham Poulter, asking whether the stock market is not just a ponzi scheme. Ah, the joys of the hyperlink.

The HIV nutrition topic is one of those that may never get finished, so onto easier topics – the stock market.

Read Graham’s original post, as well as the one by Dan Goldstein he references.

Goldstein’s post isn’t convincing, being rather simplistic. Better are S.R. Shearer’s Ponzi Schemes, the Investment Craze and the End of Days, and Dave Pollard’s The Stock Market as Ponzi Scheme.

I suggest you read those first, in particular Pollard’s piece, after which you’ll probably have no need to come back here.

Let’s strip out some of the extraneous factors, and create a simple scenario to try and understand the basics. 10 people invest at the beginning. And no one else. In the ponzi scheme, since nothing is being created, the 10 investors could only get their original investment back. Any payments to some above others, or deductions for expenses, cut into the original investment, and of course the whole thing is just a silly waste of money.

So is the stock market the same?

It seems not. If those 10 original investors invested in a company making a consistent, predictable profit (we’re stripping out all the variables here to get the basics) there is something of real financial value there. The company would pay out dividends to the investors from the profit being made. It’s a simple concept. There’s nothing unusual in that concept – the investors could be the workers of the company, outside investors, it’s not important. But, as long as the company makes a profit, there’s money to pay back. The level of profit would determine the value of the share.

If the profits were to drop, the money being paid out in dividends would drop. And therefore the share is less valuable, and the price would drop. Conversely if the profits increased.

So in a very fundamental way, there is a difference.

But let’s examine it further.

There are other factors that affect the price of a share. Future growth and future profits is of course a key one, but I’m not going to go into the notion of perpetual growth now, although it’s an important factor.

Another is supply and demand. In other words, how many people are investing in shares, or, more accurately, how much money is being invested? If the number of investors remained static, the value of the share would rise or fall based on the (for now, predictable) profits. If more money was invested in the stock market, the value of the shares would rise. If more money was being removed, the value would fall.

Much of the increase in the stock market over the last few decades has been just this. From being an activity limited to wealthy investors, now many people put their disposable income in the stock market, thanks in part to the added ease of accessibility, with tools such as unit trusts, online investing, and so on. So, the share prices increase. And the original wealthy investors, who got in earliest, benefit most of all.

Another variable is what kind of financial returns people get elsewhere. And what are the common options for someone with excess money wanting to do little with it but make more? One is put it into the bank. Bank interest is in a sense equivalent to the dividends, but without the added benefit of the increase in share value. As more money has been poured into the stock market, putting money in the bank has seemed a worse and worse option.

Another possibility is to invest in an asset, such as property, art, wine – whatever. I’m not going to go into that sort of investment now, but as the stock market has generally out-performed all those sorts of investments, it’s seemed to be the smarter investment.

Exacerbating the increase in share prices has been the huge amount of public money being invested – pension funds and so on. Money that was never invested in the stock market now is – a cycle is being created of more money going into the stock market as the returns seem more and more attractive compared to the alternatives.

What does all this tell us? The value in a share is now no longer closely related to the dividend it provides, but rather to the potential capital increase it could provide. So what would happen if, like the ponzi scheme, one day saturation point was reached and there was no more new money being invested in the stock market? There’d be no potential for capital increase. Remember, for now we’re excluding the factor of future growth, so let’s assume it’s a static figure.

At this point, the market would suffer a huge crash, and drop to a level that directly relates to the value of the dividends being paid, or the profits of the company. And all that paper money would disappear.

This huge crash is not quite a collapse in the sense of the ponzi scheme, as it would not crash to zero, but rather to some, much lower, but still significant figure. But it’s safe to say the effects on the world would be quite dramatic, and there’d be some serious upheaval.

There’s only one way to escape this conclusion, and that’s to say that growth can and will continue indefinitely, and that this extra money will continue to be invested in the stock market, fuelling it’s continual (albeit bumpy) rise.

But that’s a topic for another day.

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1 comment

  1. We all know that major banks are able to generate billons of dollars every year by trading the markets. To do this, they require the best technology money can buy a set of clearly defined rules which, are measurable and… Repeatable.

    Before we try to play the banks at their own game, or try to use the tools they use,
    we have to understand their mentality, because they are the experts at making profit on the stock market.

    Firstly , they are completely mercenary in their approach towards the market, they DO NOT CARE what stocks they buy, their sole focus is to pick stocks that have the best opportunities to make profit.

    Also, they are conservative….. not only with their funds, but also emotionally, they NEVER stray from the rules just for the lure of a ‘good buy’.
    (that’s how people loose out)

    Last but not least, they are REALISTIC….. The banks know that they can’t find profit on every trade they make. But if they stick by their rules, they know they WILL make money. If you win 70 percent of the time, and you win more than you lose, you WILL realise a profit on a consistent, weekly basis.

    Firstly, you need to determine a reason to buy, this is called an ENTRY rule, combine this with a reason to sell… the EXIT rule. Together they form your trading system.

    Next you need to test your system, personally I test it over weekly, monthly and a yearly basis to get an idea of how it would have performed in particular markets and a multitude of different circumstances in the past.

    Testing the past performance is the foundation to building a profitable trading system.
    (if you build a house on mud, it’s going to sink!)

    However, as conditions in the market change, a trading system’s effectiveness may also change.

    To ensure the system will still be effective under TODAY’S conditions, a process of VERIFICATION has to be performed.

    I use a system which allows me to use trading dollars to test each of my systems on the live market.

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