bubbles, ponzi schemes, and investments

Bubbles, Ponzi Schemes, and Investments

Dale DeBoer, Ph.D.2013

How would you know?

•The (ab)normal market

•There is no such thing

•Historical performance

S&P 500

S&P 500

5.7%

S&P 500

8.7%

S&P 500, P/E

15.7

Thinking about P/E ratios

•Suppose P/E = 10

•Price = 10

•Earnings = 1

•Rate of return?

Thinking about P/E ratios

•P/E = 15.6

•Rate of return?

Thinking about P/E ratios

•P/E = 15.6

•Rate of return?

•1÷15.6 = 6.4%

Thinking about P/E ratios

•Issues

•Backward looking

•Dividends

S&P 500, P/E

18.1

Importance of P/E ratios

•1 point increase above long run average correlates with 25% reduction in subsequent return

•Statistically significant at 1%

•Only captures 30% of variability

S&P 500

1.8%

Wilshire 5000

4.9%

DOW

2.3%

Can this be beaten?

•Without fraud!

•Risk-reward tradeoff

Can this be beaten?

•Without fraud!

•Risk-reward tradeoff

•Leverage

•Hedge funds

•$100 invested

•10% return

•$10 earned

•$100 invested

•Same investment, but only 10% down

•Interest rate 5%

•10% return on investment

•$10 earned - $4.50 paid in interest

•Rate of return?

•$100 invested

•Same investment, but only 10% down

•Interest rate 5%

•10% return on investment

•$10 earned - $4.50 paid in interest

•Rate of return? 55%

Can this be beaten?

•Without fraud!

•No fraud, but broken fundamentals

•Bubbles and the greatest idiot theory

Text

https://en.wikipedia.org/wiki/File:Tulip_price_index1.svg

2,400% over 3 months30,417,400% over 1 year

http://www.economist.com/blogs/dailychart/2011/11/global-house-prices

7.1% per year

https://www.google.com/finance?cid=13756934

40.6% per year

Series average: 3.7%“Bubble” average: 12.3%

Can this be beaten?

•Without fraud!

•No fraud, but broken fundamentals

•Fraud

http://www.finra.org/web/groups/sai/@sai/documents/sai_original_content/p337731.pdf

Can this be beaten?

•Without fraud!

•No fraud, but broken fundamentals

•Fraud

•Insider information

http://www.sec.gov/spotlight/insidertrading/cases.shtml

Can this be beaten?

•Without fraud!

•No fraud, but broken fundamentals

•Fraud

•Insider information

•Ponzi schemes, pyramids, and Herbalife(?)

Charles Ponzi

•International exchange coupons and arbitrage

Charles Ponzi

•International exchange coupons and arbitrage

•Investors needed

•Initial promise: 50% every 90 days

•Subsequent promise: 50% every 45 days

Charles Ponzi

•International exchange coupons and arbitrage

•Investors needed

•Making the payments

•Withdraw or reinvest?

Charles Ponzi

•International exchange coupons and arbitrage

•Investors needed

•Making the payments

•The importance of the individual at the center

A pyramid

•The “Prosperity Club” letter

•Denver, 1935

http://www.silcom.com/~barnowl/chain-letter/archive/me1935-05-20br_sd_club.htm

A pyramid

•The “Prosperity Club” letter

•The power of exponentiation

•8 rounds: 390,625

•15 rounds: 6,103,515,625

The Herbalife question

•Bill Ackman

•Pershing Square Capital Management

•“Pyramid schemes like Herbalife [are] particularly vulnerable to product-quality concerns”

The Herbalife question

•Bill Ackman

•Multi-level marketing

•Is it different from a pyramid?

•The question of product

An economists simple look at

investing

Paul Samuelson

•“Investing should be dull. It shouldn’t be exciting. Investing should be more like watching paint dry or grass grow.”

•The parable of 64 monkeys

The Efficient Market Hypothesis•Markets (and market prices) reflect

all information

•What information is this?

•The question of $20 on the sidewalk

•Evidence?

http://www.ifa.com/Media/images/PDF%20files/Malkiel_PassiveInvestmentStrategiesandEfficientMarkets%20(2).pdf

Even if not true...

•Can you beat 31,000?

Even if not true...

•Can you beat 31,000?

•7 milliseconds!

Even if not true...

•Can you beat 31,000?

•7 milliseconds!

•You are not the bank

Avoiding mistakes

•Seven Deadly Sins of Investing• http://online.wsj.com/article/SB1000142412788732490630457903716308

0446646.html

•Lust: Chasing Recent Performance

Avoiding mistakes

•Seven Deadly Sins of Investing• http://online.wsj.com/article/SB1000142412788732490630457903716308

0446646.html

•Lust: Chasing Recent Performance

•Pride: Being Overconfident

Avoiding mistakes

•Seven Deadly Sins of Investing• http://online.wsj.com/article/SB1000142412788732490630457903716308

0446646.html

•Lust: Chasing Recent Performance

•Pride: Being Overconfident

•Sloth: Overlooking Costs

Avoiding mistakes

•Seven Deadly Sins of Investing• http://online.wsj.com/article/SB1000142412788732490630457903716308

0446646.html

•Lust: Chasing Recent Performance

•Pride: Being Overconfident

•Sloth: Overlooking Costs

•Envy: Wanting to Join the Club

Avoiding mistakes

•Seven Deadly Sins of Investing• http://online.wsj.com/article/SB1000142412788732490630457903716308

0446646.html

•Wrath: Failing to Admit Failure

Avoiding mistakes

•Seven Deadly Sins of Investing• http://online.wsj.com/article/SB1000142412788732490630457903716308

0446646.html

•Wrath: Failing to Admit Failure

•Gluttony: Living for Today

Avoiding mistakes

•Seven Deadly Sins of Investing• http://online.wsj.com/article/

SB10001424127887324906304579037163080446646.html

•Wrath: Failing to Admit Failure

•Gluttony: Living for Today

•Greed: Following the Herd

Four “Rules”

•Save enough

Four “Rules”

•Save enough

•Control expenses

•Management fees

•Trading costs

•Taxes

Four “Rules”

•Save enough

•Control expenses

•Diversify

•Does this conflict with “control expenses?”

•The virtue of ETFs and Mutual Funds

Four “Rules”

•Save enough

•Control expenses

•Diversify

•Reallocate