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Ponzi-Proof Your Portfolio

What is the difference between the stock market and a Ponzi scheme? And how do you protect yourself from this kind of fraud?

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 :

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 $38 per share (as of Tuesday night).

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 $171 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.

Lou Dagen is a Certified Financial Planner in the San Francisco Bay Area. For 23 years, he has helped clients around the world retire in comfort, educate their children, and increase their net worth. If you have questions, please post them in the comments below or call Lou directly at 925-997-8507.

This post is contributed by a community member. The views expressed in this blog are those of the author and do not necessarily reflect those of Patch Media Corporation. Everyone is welcome to submit a post to Patch. If you'd like to post a blog, go here to get started.

Californicated1 February 09, 2013 at 08:01 PM
Once again, I am going to repeat myself, here, with what I just posted above about the great "fiction" and its use in advertising the scheme-- "You can't win if you don't play." And once again, it is the fiction generated by the lure of easy money and instantaneous gain, all on the hopes that the lottery ticket this gullible person bought, believing that if they played, they had a chance of winning. And once again, if enough people were gullible enough (cue the famous P.T. Barnum adage), not only would it increase the amount of money one could win, but also increase the amount of money that the scheme's sponsors would ALWAYS be making in this scheme, no matter who won or who lost playing in this scheme. And that's definitely a "Ponzi Scheme". And when the state is involved in this scheme's sponsorship, no matter how benevolent their intentions, they are still preying on the people gullible enough to buy tickets on that fiction that they too could win if they played. And in a lottery scheme, a Carlo Ponzi would be there running it, promising the winner a big payout, skimming his monies from the pool everybody that bought a ticket paid into. And one of the things we hear about in the news is always the big payout, but very little attention is paid to all the people that paid for tickets and what other fees were paid out or taken out by the sponsors of that lottery. All based on selling the fiction that a person could win just by playing.
John February 10, 2013 at 08:19 AM
Cali.....The government is printing money at a fairly significant pace and buying mortgage back securities and supporting the Markets....It's been going on for a few years...This is being done around the world....If they didn't the housing markets would have collapsed and the stock market would also.....Plus it would destroy the tax bases in every City, State, and at Federal level if they didn't support.....We have got ourselves into a pickle and the powers at be think this is the way to go.I think the total Net inflows into the Market in January were 15 Billion...The Government added 84 Billion in January....They Will add 1 Trillion in 2013 adding 84 billion a month...Lou knows a lot more than me , but that is my understanding. I don't think its Lou's intention to suck you into a ponzi scheme....There are fabulous companies making great returns and offering fair value..There are mediocre companies out there also along with some bloated and inflated stocks. If I read his article correctly is do your homework and ask questions... This Country was built by great Business.Everyone can't work for the Government.
Californicated1 February 10, 2013 at 03:03 PM
...[D]o not believe every spirit, but test the spirits to see whether they are from God, for many false prophets have gone out into the world. (I John 4:1) If you have seen "Justified" thus far, you probably recognize the scene by which that line comes from. And that is how this Financial Planner is coming across to me--like some "tent revival snake-handling preacher" wowing his crowd with his ways of word and now letting the "faithful" trying to sell us his version of "salvation". The reality here is that you can't trust this person with his financial advice any more than you can trust any other person out there that calls themselves a financial advisor, whose advice may not be any more sound than your next-door neighbor's, even if they happened to be financial planners themselves. And when this particular financial advisor is telling us about how to "Ponzi-proof" your investments, always be aware that Ponzi Schemes are not always going to "stick out like sore thumbs" and be easily identifiable as Bernie Madoff proved, when it was found out he was operating his scheme since the early-1970s and it wasn't discovered until 2009, when he first confessed to his sons who were about to inherit his business all the great wrongdoing that he did to his customers. And ultimately it was the sons of Madoff who turned him in to the authorities, because they, like the rest of the financial community, had no clue that Madoff was running a Ponzi Scheme.
Chris Nicholson February 10, 2013 at 04:44 PM
@Cali: It sounds like your beef is not with Lou as much as it is with our whole capital markets system. Flawed as it surely is, it is the best in the world by most measures (including regulation, investor protection and transparency). If I thought I could make a safe, decent and stable return doing so, I would keep all my assets in the form of gold bars stashed in a safe somewhere. But I can't, so I am forced to take on lots of flavors of risk which, by my estimation, are better on a risk/reward basis than betting on the price of gold over the next few decades. In general, I am all for ranting, but your Perpetual Ponzi Protestations are kinda getting old.
Californicated1 February 10, 2013 at 05:05 PM
When it comes to anybody doling out advice, no matter how "professional" they seem or with what authority by which they seem to be dispensing that advice from, always be mindful that advice is always out there, always recommending to do one thing or another. And when it comes to money matters, there is this Latin phrase that one should always keep in mind--- "Caveat Emptor" Translated into English, albeit idiomatically but then again most translations are based on idiomatic interpretations that the interpreter brings into their interpretation, it means "buyer beware" or "let the buyer beware". And in forums like this, advice is always cheap, even from a source like me, the host of this forum and even you, Mr. Nicholson. You can always take the advice you want, set aside what you don't, and believe what you want to believe. But be prepared to encounter skepticism, cynicism, optimism even along with some ranting and rancor, praise and castigation in any writing, especially where some sort of advice is being put forward, promulgated, or even proselytized and prophesied. And if somebody wants to sell you salt, make sure it isn't urine with the water taken out of it, which in turn could prove to be more hazardous to one's health than the salt would be because of the other chemicals that may be present and that could be toxic.

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