Saradha a classic Ponzi schemes: Why there will be more suckers

In Ek Thi Daayan, the latest horror flick to come out of Bollywood, the dying daayan (witch) says something to the effect of "main wapas aaongi (I'll be back)." Ponzi schemes are a tad like that. They keep coming back one after the other.

Only some time back we were talking about the Stockguru ponzi scheme. Before that the emu ponzi scheme and Speak Asia had been in the news. More recently the MMM Ponzi scheme and Saradha chit fund have taken up a lot of news space.

MMM India recently put itself into what it calls a calm regime where operations like money transfer will remain suspended and hence those who have put money into the scheme won't be able to withdraw it. The Saradha Chit fund has collapsed.

The question is why do Ponzi schemes keep occurring over and over again in India? A popular explanation is that India is an under-banked country and that gets people to invest in Ponzi schemes rather than deposit money in the bank.

As The Economic Times points out in an editorial, "the repeated sprouting of dubious Ponzi schemes across the country points to a failure of the formal saving and banking system." This maybe true to some extent but does not really explain why Ponzi schemes keep cropping up all the time and why people invest in them.

PTI

PTI

Take the case of MMM India Ponzi scheme. To participate in it, an individual needed to have a bank account. To be a part of Speak Asia, an individual had to participate in two online surveys per week. An individual who has access to an online connection is more than likely to have a bank account as well.

So Ponzi schemes are not just about India having fewer banks. There is a clear mental dimension at play which makes individuals invest in Ponzi schemes over and over again. And this makes sure that there are always scamsters looking to cash in.

Robert Shiller, an economist, defines a Ponzi scheme in a research paper titled From Efficient Market Theory to Behavioural Finance as follows: A Ponzi scheme involves a plausible but unverifiable story about how money is made for the investors. It creates a false perception of high returns for initial investors by distributing to them money brought in by subsequent investors. Initial investor response to the scheme tends to be weak, but as successive rounds of high returns generate excitement, the story becomes increasingly believable and exciting to investors. Finally, the scheme collapses when new investors are not prepared to enter the scheme.

The phrase to mark in this definition is "high returns generate excitement". Very recently, MMM India promised returns of 100 percent per month to prospective investors. The promise of high returns pushes individuals to take on the risky bet of investing in a Ponzi scheme.

As Robert Shiller writes in Finance and the Good Society, "The mere presence of uncertainty in a positive direction creates a pleasurable sensation (in the brain), and so the reward system creates an incentive to take on risky positive bets...This human tendency also helps explain why people like to gamble, and why many people will return every day to bet a small sum in a lottery. It also helps explain why people are willing to speculate aggressively on investments."

This gets individuals to invest in a Ponzi scheme. And after one lot of investors has invested in a Ponzi scheme it tends to take on a life of its own. The initial lot of investors then become advertisers for the scheme. If a person wants to invest, the chances are he will look around to see what his acquaintances, neighbours or relatives are doing with their money. If the people around the potential investor invest in a certain way, there might be a tendency for him to follow them. Much like the 'circular mills' of ants. The mill is created when an army of ants find themselves separated from their colony. Once they are lost they obey a simple rule: Follow the ant in front of you.

Decisions of investors, much like the circular mills of the ants, are not made at the same time but in a sequence. People who invest in the Ponzi scheme assume that the scheme is a good bet simply because some of the people they know have already invested in it. So everyone ends up making the wrong decision because the initial investors get into the scheme by chance.

Protests against the Saradha group. PTI

Protests against the Saradha group in Siliguri. PTI

This happens because the attraction of easy money is something that investors cannot resist. Ponzi schemes offer the prospect of huge returns in a short period of time vis-a-vis other investments available in the market at that point of time. Greed also results when investors see people they know make money through the Ponzi. As Charles Kindleberger wrote in Manias, Panics and Crashes, "There is nothing so disturbing to one's well being and judgement as to see a friend get rich".

Overconfidence also has a part to play. Most people are confident that they won't become victims of financial frauds. This also leads them to invest in Ponzi schemes. Overconfidence is also at play when investors understand that they are getting into a Ponzi scheme, but they are still willing to enter the scheme, because they feel that some greater fools could be depended on to enter the scheme after they have and this would give them handsome returns on their investments.

The contract effect is also at play. It becomes relevant in the context of a Ponzi scheme when the prospective investor starts comparing the returns on the various other investment avenues available in the market at that point of time. The high returns of offered by a Ponzi stand out clearly and attracts investors.

So a Ponzi just doesn't spread only because of a weak banking structure though that might be true in the case of Sahara or even Saradha chit fund. Also it is important to remember the first sentence in Shiller's definition of a Ponzi scheme, which is: "A Ponzi scheme involves a plausible but unverifiable story about how money is made for the investors."

So people running Ponzi schemes spend a lot of time building a 'supposed' business model and a great brand. The Saradha chit fund had built a huge media empire in West Bengal. It had also purchased a motorcycle company, to give some semblance of a business model to its investors.

Sahara is similarly into a lot of businesses and even sponsors the Indian cricket team. Similarly, Speak Asia was in the magazine and survey business. It also advertised in publications of The Times Group, to build credibility. Emu Ponzi schemes were in the business of rearing and selling emus. And Stockguru helped investors make money by investing in stocks.

MMM, in its original Russian avatar, sponsored the Russian football team in the 1994 world cup. When questions were raised about the huge returns it had promised, MMM stated that it had solid investments, but did not want to disclose them as its competitors might imitate its investment strategy.

Investors in Ponzi schemes ignore the most fundamental principle of investment theory: You cannot expect to make large profits without taking risk. Whenever a large amount of money is at stake, individuals should logically seek large amounts of information on where they should invest. But most investors do not do so. Few ask the right questions at the right time and are nave enough to believe in what is communicated to them by the people carrying out the fraud.

Indeed, many Ponzi Schemes do not get reported as people do not like to admit that they have been fleeced because of their greed. The ones which are reported and investigated get stuck in the quagmire of our legal system. This encourages more people to run Ponzi schemes. And every time a Ponzi scheme is exposed, the confidence of the investor in the financial system goes down.

The most commonly suggested solution for the prevention of Ponzi schemes is sharing more and more information with the investing public. But research in psychology shows that more information does not necessarily improve judgment. Any extra information is helpful only if it comes without any bias. But that is rarely the case. Moreover, the ability of the common man to assimilate information is limited.

Rather than assuming investors are knowledgeable about investment opportunities, the best solution to the problem of Ponzi schemes might be ensuring swift legal mechanisms to punish the unscrupulous masterminds behind the schemes. This will ensure that every prospective fraudster will think twice before launching another Ponzi scheme.

Vivek Kaul is a writer. He tweets @kaul_vivek


Updated Date: Dec 20, 2014 19:15 PM