Why there will always be pyramid schemes

A curiosity of the coverage of the $50 billion Madoff scandal was the sense of shock and surprise that professional investors made big, possibly illegal, mistakes in 2008. The same year half our banks fell apart, major investment firms went bankrupt, automobile companies beg for money, and governors offer to sell senate seats for cash. In August of 1920 Charles Ponzi was charged with similar crimes and it’s clear in the future it will happen again.

In discussions like these a book gets mentioned by some experts called Extraordinary Popular Delusions and the madness of crowds. It’s a big fat book chronicling the silly, absurd things large groups of people have bet their money on and lost. Some read the book to feel smart smart that we ourselves didn’t do any of the stupid things our ancestors did. But these days an update to the book is well overdue: an entire chapter can be written about the delusional wonders of our generation.

I’m left with this opinion: there will always be pyramid schemes, frauds and market collapses. It’s inherent in complex systems, things like democracies, free-markets and blogospheres, that these things will happen. It’s unavoidable. I’m not saying we should accept them or not try to reduce their  impact (hello, SEC, where have you been?), but they will always take place. The reason? Trust.

A pyramid scheme, often referred to as a ponzi scheme, is well defined by wikipedia as an unsustainable business model, where the people who invest are not aware of how unsustainable it is. (In a ponzi scheme, victims are mostly just out of luck, in a pyramid scheme, victims are often part of the crime since they promoted the pyramid).

As the story goes the legendary Charles Ponzi told his potential investors in 1919 he could return 40% on their money in 45 days. FORTY PERCENT. At a time when the interest rates hovered around 5%. Why was he able to get their money on such a ridiculous promise? For one reason: they trusted him. That’s it. He found a way to earn their trust. The details don’t matter for the moment. Lets ask what is trust?

Trust is using what you know about someone to compensate for what you do not know. I trust my brother. I’d trust him to, I don’t know, say, watch my dogs. Now once he has my dogs I can’t be 100% certain what he might do when he watches them. He might decide to cover them with chocolate syrup, or set them loose in the meat section of my local supermarket, I can’t prevent him from doing these things. But I trust he won’t.

Similarly you trust the staff at McDonald’s not to spit in your food, the woman behind you at line in the bank not to make silly faces at the back of your head, or the gas you pump into your car to be actual gasoline and not turpentine. Our daily lives hinge on trusting all sorts of things we are too ignorant or busy to verify. And from time to time some people will take advantage of this trust because they are mean and because they can. It might only happen 1 or 2% of the time. Small enough not to make us stop trusting these things. But fraud, abuse, and pyramid schemes will always exist as long as we are free to choose who to give our trust to. Laws penalize people after they betray our trust, not before.

Look at the list of people whose trust was betrayed by Madoff: Steven Spielberg; Jeffrey Katzenberg, Sen. Frank Lautenberg (D-N.J.); New York Mets owner Fred Wilpon, fashion mogul, Carl Shapiro; real-estate developer Mortimer Zuckerman; the European bank HSBC; and on it goes. These high powered people, despite their teams of lawyers and advisers had their trust betrayed. It’s sad and shameful what happened, especially since many of their funds were tied to charities, but there’s nothing we can do to permanently prevent this from happening again. To hire someone to manage your money will always be based primarily on the wonderfully imperfect, intuition dependent, amazingly tricky thing called trust.

How do you decide who to trust? All I know is after writing this post, I’m looking at everyone I see with a suspicious eye :)

[Note: minor edits made 8/4/2014, changing references to 2008 to present]

11 Responses to “Why there will always be pyramid schemes”

  1. Mike

    Another question would be: “Can trust be built?”, e.g. does eBay’s feedback system establish trust? You made some good points there.

    Can I trust my own instincts? Can I trust my own judgment? We all know how many times our mind plays tricks with us. Surely there stays always a margin of uncertainty when trying to predict the behavior of a future event or relationship one will/wants to rely on. Much depends on ethical codes (or laws) and social influence.

    But to answer your question: one of my friends always used to say: “To trust me is always a mistake”. I’d trust him most :)

  2. Scott

    Mike: excellent! A fellow philosopher.

    What makes trust interesting is the possibility of it not being warranted. If people had the word “TRUSTABLE” stamped on their forehead as part of guarantee from the universe that they were 100% trustworthy, what would be the point of trusting anyone else?

    Part of the game in being a trusting person is to realize that some of the people you trust will let you down. But that’s ok. The only way to sort out who you can trust is by giving it to people, and learning from what they do with it.

  3. Percy

    You have to also consider that people are strangely trusting when it comes to their finances, as in they’d rather not get into the details of how and why and will make decisions without doing adequate research. (I think John Rhodes of WebWord wrote a post about this a while back.)

    When it comes to money, there’s also the “greed factor” to consider. You may feel that a certain scheme isn’t up to the mark but if it is paying out a lot of money, then your greed might cause you to rationalize the feelings of mistrust you may have.

    But, in the end, trust involves a leap of faith–there’s no way around that.

  4. Scott

    Percy: Hmmm. I don’t know. I guess it depends on the person, you know? For all the people I can think of who are too trusting with their money, I can think of just as many who don’t trust enough (myself included in this pile). The sample size of my acquaintances is skewed in all sorts of ways, but I have trouble getting behind the assumption that people are more trusting with their money than other things in their lives. But I’d love to be convinced if you’re willing to give it a shot.

    And the thing your comment made me think is part of what (some) people want are big returns, and they are aware of the risks that come with that. So even when an investment fails, they can still possibly trust their broker or agent or whatever, since they were aware all along that there were risks beyond the control of all involved.

  5. tkoehl

    A wise president used the phrase, “trust but verify) when it came to discussing arms agreements for our country. The more important the thing to be risked is to you, the more important it is to verify, by your own skills or through a third (or fourth) party that is and expert who works for you.

    You may still get ripped off but you’ve reduced the likelyhood it will happen. Also, it is prudent not to risk with others any more than you can afford to lose.

  6. Percy

    Scott: For the record, I’m pretty skeptical myself when it comes to trusting people with my money. :-) You’ve raised some interesting points I’ll try to clarify what I was saying.

    I guess when I was writing my comment I was thinking about a scheme (in India) called Chit Funds, which is sort of like a ponzi scheme. Almost every year you have cases of thousands of investors being defrauded by unscrupulous people and yet these investments still keep going. (The investors are usually middle class people who have a lot to lose.)

    What I mean by their keeping going is that if someone not yet trustworthy (with no previous record for instance) offers a chit fund scheme it’s highly likely that people will invest. I don’t know why people behave this way.

    My guess though is that some people think of risky investments like most people think about death. (Not being morbid here.) Most people know that they are going to die but most hope (and reasonably so) that they’ll live till a certain age–long enough to get married, have kids, buy a house, etc. I think that with risky investments people know about the risk but they are hopeful in the sense that they think, “I know this happens but it won’t happen to me.” So, I think that while some people may be aware of the risks, deep down they may not believe that they are exposed to that sort of risk.

    The point regarding people being more trusting with their money than other things in their lives comes down to, in my mind, how well people understand financial instruments/products. From what I’ve seen, most people typically either don’t take the time to understand these products (some of which are complex) or rely on the advice of someone (trusted person) who’s already invested in a product, a person who may or may not have understood the product himself. (For example, and this isn’t the best one, with credit cards I know that lots of people ignore the fine print and sign the dotted line without realizing what the interest rates are, how they work, etc.)

    Hope I’ve clarified my earlier comment a bit better.

  7. Gordon

    Francis Fukuyama wrote a whole book on this topic. Imaginatively, the book is called “Trust.” One of the best books I have ever read on culture in business and, in many ways, Fukuyama was spot on with his warnings in the book. It’s also a fantastic book if you are interested in the relationship between trust and firm size.

  8. Scott

    Gordon: thanks for the recommendation – I made it a link to the book on amazon.

  9. Joson

    This is the reason why we need to build character( what one does when nobody is watching). How to build character? Well, everybody knows the answer.

  10. Scott

    Joson: You can’t leave me hanging like that. How do you build character?

  11. Joson

    Elementary Mr. Scott. Just kidding :-). Anyway, simple basics

    Parents and school teachers of all levels must make investments on young minds to instill right values. The specifics are irrelavent of how they make that investment. Everybody without exception can distinguish a right from wrong as far as values are concerned. Of course one can play with words and say right and wrong values are subjective. Well, that subjectiveness will not fly with people who are victims of those “Subjective” decisions.

    E.g. Watch this video and nothing can explain more what I mean.



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