Ponzi Schemes Explained - For you Elise!

I have to admit, I have been totally slacking on my blog posting lately. I have had many good ideas to blog about but I just keep putting it off like a bad blogger. I am trying some new motivational techniques to keep me on point, but the whole reason I am blogging to begin with is for motivation so what I am left with is a huge motivational “hairball” that ends up becoming anti-motivational! What a mess!

Anyway, Elise wanted me to write about Ponzi schemes and how all the stuff that Bernie Madoff did can be considered Ponzi in nature. After some contemplation, I decided that a complete explanation would be way too long for the blog, so bear with me for the abridged explanation.

Wikipedia defines Ponzi scheme (named so after Charles Ponzi, who popularized the idea) as “a fraudulent investment operation that pays returns to investors from their own money or money paid by subsequent investors rather than from any actual profit earned”. In my opinion, the biggest Ponzi scheme ever is Social Security. The way Social Security works (at least in America) is that today's working generation pays, as a portion of their income tax, a contribution to the Social Security Trust Fund which is in turn used to fund the Social Security checks that are issued today. This is a classic Ponzi scheme and is not too much different from what Madoff was doing with his clientèle.

Madoff, being a powerful Wall street individual, was requisitioned by many of his friends and counterparts to manage their investments for them in exchange for healthy commissions. This is not all too much different from how Financial Consultants (the guys at Morgan Stanley and Smith Barney) make a living. What Madoff eventually realized was that as long as his clients’ portfolios were doing well (10%+ annual returns), they was more likely to leave their money untouched and not withdrawal contributions. It is only when portfolio values begin to fall that people consider cashing them in (thoughts we have all shared lately). This predictable facet of human behavior is what Madoff was eventually able to prey on. Once his managed account got large enough (probably around $500 million) he began sending his clients fictitious annual statements that reported amazing returns even though the money was not even being invested in any securities at all. Instead, he was depositing the funds in his bank account and getting rich! Only when an investor decided to "cash out" did he have to make any real payments and this seldom happened on the count of the fact that his investors thought they were getting phenomenal returns!

Classic Ponzi schemes do not generate any real wealth or return on investment which makes them appear to be much better in nature than they actually are. Investors can be fooled into thinking that they are receiving real returns, as many Americans who benefit from Social Security income so believe, but in reality these schemes only tie up money that could otherwise be invested in legitimate instruments that generate real returns. Just think, if instead of paying 7% of your income (lets say average take home is $20,000) to the Social Security Ponzi scheme, you put that money in an interest bearing savings account at 5% (the average for most money markets) you would have $689,657.36 after thirty years. That is enough to pay out $34,482 a year for 20 years! Way better than Social Security and you are not screwing your grandchildren out of 7% of their income!