Business failure: Survivor investing

Enterprise / 17 January 2012

Unwise investment schemes can survive and even thrive on a supply of foolish investors, says Tim Phillips. But when that supply runs out, it can bring down whole companies

It has been quite common to allege that everything from the stock market to the welfare state is a 'giant Ponzi scheme'. While any idea that uses fresh investor money to pay dividends to existing members has a whiff of Ponzi about it, a true Ponzi scheme needs a supply of greater fools to keep going.

The greater fool theory is that an investment can be both foolish and successful – as long as there is someone more foolish than you to take it off your hands at a higher price. Also called survivor investing, it has been proven to work (for a short time, at least) by bubble economics, which shows us that there is a rich supply of such fools.

Foolish behaviour

So why do we fall for these schemes? We might think that we ourselves are only fools because of a lack of available information.
 
Investment is increasingly complex. Valuations and projections are routinely given to us either using generally accepted accounting principles (GAAP) measures, which means they can't easily be compared, or is consolidated at a level that makes it difficult to spot which revenues come from which place.
 
Outside the financial sector, essential business services are supplied by outsourcers or semi-autonomous business units. Specialists create entities with bright ideas, producing returns that make your core business seem dowdy and gradually suck more and more investment out of that core.

Yet managers also have more access to information, computation and analysis than at any time. Why can't they spot the frauds?

Analysis alone doesn't stop us from being a fool. Many successful Ponzi frauds could have been spotted without recourse to complex analysis. The man who blew the whistle on Bernard Madoff, for example, managed to spot it was a Ponzi scheme in his lunch hour. It just took years to convince anyone else; they didn’t want to look.

The greater fool problem is, more accurately, a problem of too much enthusiasm chasing too little genuine good news. So we place our trust where others have placed it, and look for evidence to justify what we did. The flow of fools makes us look smart for a limited time.

We place our trust where others have placed it, and look for evidence to justify what we did. The flow of fools makes us look smart for a limited time.

Tim Phillips

In this situation, the greatest asset a company can have – which Ponzi understood very well, and which Bernard Madoff expanded to unimaginable proportions – is unshakeable investor confidence. Confidence doesn't simply reflect success, it creates it.

In the long run, the rules of economics will dominate, but a fraud like Madoff's shows that the long run can be very long indeed. He was first investigated in 1992, when the Wall Street Journal reported that "regulators feared it might all be just a huge scam". They were right, but it took 17 years, and many failed investigations, to come out.

Suspicious minds

We are routinely told to question a winning strategy. But when we work with colleagues who constantly raise doubts about the successful parts of the companies in which we work, the best that the nay-sayers can hope for is to be politely ignored. At worst, they become troublemakers. It’s seen as bad for morale to question success too hard and too often.

The heroes of a crash, after the fact, are those troublemakers. The global financial crisis was foreseen by a few people who were generally ignored at the time. When the world is in the grip of greater fools, status alone can't guarantee that your warnings are heeded.

In 2005, Raghuram G Rajan, then chief economist of the International Monetary Fund, presented a paper at the annual Jackson Hole monetary conference; he set out his argument that financial development had made the world riskier.

Bank employees, he pointed out, had clear economic incentives to take risks that were concealed from investors. Investment managers "will tend to feed risk rather than restrain the appetite for risk".

The paper made minor news, but was largely ignored by the press and financial industry until it was proved correct. The fundamental problem it raised has not been corrected, and the institutions involved aren't jumping up and down to point this out.

If we are prepared to act as fools, there are many around us, even in our own companies, who have every incentive to encourage us.

Tim Phillips is a freelance journalist and author of Fit to Bust: How Great Companies Fail, published by Kogan Page, £14.99