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5:31 am - Sunday March 26, 2017

Is the Stock Market a Big Ponzi (Madoff) Scheme?

| Economics, Psychology | Rating: 4.5
by Numan

Looking into the notion of the western financial markets as a big pyramid scheme

I’m sure many of you are familiar with the tale of monkeys and villagers that cleverly demonstrates certain aspects of the stock market. Here’s a short version for those of you who aren’t.

Of moneys and pyramids

Once upon a time in a village, a man appeared and announced to the villagers that he would buy monkeys for $10 each. The villagers, seeing that there were many monkeys around, went out to the forest and started catching them. The man bought thousands at $10 and as supply started to diminish, the villagers stopped their effort. He further announced that he would now buy at $20. This renewed the efforts of the villagers and they started catching monkeys again. Soon the supply diminished even further and people started going back to their farms. The offer increased to $25 each and the supply of monkeys became so little that it was an effort to even see a monkey, let alone catch it! The man now announced that he would buy monkeys at $50! However, since he had to go to the city on some business, his assistant would now buy on behalf of him. In the absence of the man, the assistant told the villagers; “Look at all these monkeys in the big cage that the man has collected. I will sell them to you at $35 and when the man returns from the city, you can sell them to him for $50 each.” The villagers rounded up with all their savings and bought all the monkeys. Then they never saw the man nor his assistant, only monkeys everywhere!

At times such as the one we are experiencing now it is very tempting to claim the stock market and western market economics are all one big Ponzi scheme as Nassim Nicholas Taleb , the author of the black swan theory, recently did.

The western financial systems as Ponzi schemes

Mr. Taleb is a philosopher and a former derivatives trader, whose black swan theory deals, in a very insightful manner, with the affect powerful yet random occurrences may have in any field (a black swan as a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations).

The sub-prime crisis and the following credit crisis are huge black swans for that matter. Nassim Taleb enjoys the reputation of one of the few who foresaw the crisis.

According to Mr. Taleb, as was stated in a recent interview, the western financial society is based on a pyramid scheme, much like the Ponzi or Madoff schemes. We needn’t take this statement to the letter but rather regard it as a notion to consider.

As many philosophers before him, I believe Mr. Taleb is offering a fresh perspective on an existing notion, in this case financial markets, which we should use to review our set ways of thinking.

In the headline I chose I asked whether the stock market is just a Ponzi scheme, a headline that wrongs Mr. Taleb’s argument. The stock market is a means to an end: a tool to raise capital. Mr. Taleb “goes after” the western financial system that failed us.

The main argument is that investment banks and brokers usually risk other people’s money and benefit on the upside only. This is a powerful argument with the results of which we can’t really argue.

The tools of the trade are often complicated models which justify what they were built to justify while ignoring other important parameters. The already known end is usually a bubble busting, one size or the other. Models are simplifications of reality, that is their strength and weakness. Every model must be taken with a pile of salt.

By increasing the level of risk taken with other people’s money bubbles are cyclical and are destined to explode eventually. Since the human mind is not very adept at dealing with risks objectively and is apparently very good displaying herd behavior the markets simply follow this cyclical pattern with investment bankers making a fortune every other 6 years or so.
The pyramid element is very strong. If you can either time the trend, or better yet create it, then you’re one of the lucky few who put their money first. Chances are that like many other household investors, we’d be too late to really enjoy the party. What can we do? Simply be there, reserved yet present, through the good times and the rough.

Being aware is already a good starting point

There’s no need to adopt a fatalistic approach to financial markets and keep all our money in ultra solid investments. Being aware of market dynamics and the structure of our “western” markets is important for financial survival and to taking advantage of the benefits they do offer.
We all enjoy the possibilities our financial markets offer. Our pensions, for example, are dependent on the market’s performance. Even with bubbles bursting and crisis manifesting markets have displayed positive returns in the long term.

There is a solid basis and economic justification for the western financial markets and obviously claiming they are all a big pyramid scheme is too extreme. There is truth to the argument as I’ve discussed but there obviously so much more.

As the cycle continues regulation will be enforced more firmly, the fear will keep the markets at bay. Still, as the economy starts expanding again the perceived level of risk will decline again and the bubble will burst again.

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