Everyday Financial Guide

January 9, 2012

How Pyramid Schemes Work

Filed under: Investing — Tags: , , , , , , , — thefranksteak @ 1:12 pm

The truth is that pyramid schemes never actually work. A few people make some money from such a scam but most suckers lose every cent they invest. The reason such enterprises cannot work is that their success is mathematically impossible.

The Pyramid Scheme Explained

A pyramid scheme or Ponzi scheme is any sort of fraud in which a con artist uses money collected from later investors to pay off earlier investors.

A typical scheme works like this: Joe Sleaze sells the suckers in Dumbville several hundred shares of worthless stock. Next Joe travels to Suckertown where he sells several hundred more shares of worthless stock. Mr. Sleaze then pays the suckers in Dumbville with the money he collected from their brethren in Suckertown.

That way it looks like the worthless investment is making money when all that is really going on is that Joe is selling shares. It turns the earlier investors into marketers for the con game because they tell everybody about the “profit” they made on the investment.

The problem is that sooner or later Joe is going to run out of suckers. When he cannot sell any more shares the pyramid stops making money and collapses.

Pyramid Schemes Can Take Many Forms

Even though all pyramid schemes operate in much the same way they can take many forms. Con artists love the pyramid because they can use it to sell almost anything and finance the scam with the suckers’ money.

Many investment scams, particularly those that involve derivatives or accounts receivable loans are pyramid schemes. Other common variations include offshore investments, hedge-futures trading and high-yield investments. Bernie Madoff’s investment scam was a pyramid because he was paying investors off with other investors’ money. Many network and multi level marketing businesses are actually pyramid schemes.

Quite a few scams perpetuated by shady investment advisors are also pyramids. Even securities dealers working for major national brokerages have been caught running pyramid schemes. In 2004 the SEC fined Raymond James $6.9 million because one of its brokers, Dennis Herula was involved in a scheme.

Math dooms the Pyramid

The one thing all of these frauds have in common is that they cannot work. A simple mathematical analysis proves they will collapse.

Math shows that a simple multilevel marketing con that required each marketer to recruit four new suckers would run out of suckers in just 12 levels. If the marketer recruited four victims each of them would have to recruit four victims. That would be 64 marketers. If they kept it up for 12 levels the marketers would have to recruit 13.8 billion people to sustain the racket. Since there are only 7 billion people in the world it’s obvious this cannot work.

Every other pyramid scheme is doomed by similar numbers. The only way the con could be sustained would be with an endless supply of suckers.

Why People Fall for Pyramid Schemes

The main reason people fall for a pyramid scheme is that they refuse to investigate what they are investing in. Fraudsters count on the fact that a lot of people look only at the fast money and fail to ask how the scheme works.

Most victims could avoid being taken if they simply asked what was going on. Quite a few people fall for such scams perpetuated by people they trust. They see a friend or relative making money and decide to cash in. If somebody recommends an investment check it and the person or organization behind it out carefully. An easy to perform such an investigation is to run an internet search on the investment and those behind it. If there are complaints, criminal charges or lawsuits the search will probably turn them up.

Always be leery of investments sold through informal or nontraditional channels such as social contacts and anything that promises big returns or fast returns. If you cannot figure out how something is going to make money refuse to invest in it. If you see somebody else making money from something you believe to be impossible chances are it is a pyramid scam.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Annuities Explained, Fixed Income Annuity, and Annuity Leads.

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How Indexed Investments Work

An indexed investment is designed to give average people a simple automatic investment that limits risks while maximizing gains. Essentially an index is a lazy man’s investment, the investment itself is supposed to manage risks and move with the economy. All the investor has to do is sit back and watch his money grow.

These tools are based on a powerful investment strategy called indexing. Indexing is basically a risk management tool that has a side benefit of maximizing gains if it is used properly.

Indexes Explained

An index is nothing but a list of stocks. An indexed mutual fund or exchange traded fund is a trading company that buys a number of shares of every stock on the list.

Indexes can be based on anything you could have an index of all companies with names beginning with P. Some indexes track an economy or market, S&P 500 indexes try to track the entire US economy by owning stock in the 500 largest companies in the US. Other indexes will follow an industry such as gold mining or a foreign country’s economy.

The idea behind this is to reduce risk by holding many different stocks the investors will be less likely to lose money if one company fails. They are also supposed to protect investors against economic downturns. An S&P 500 index would presumably include stocks in companies performing well under current economic conditions. It would also own stocks that would increase in value with the economy.

If the overall market fell but pharmaceutical stocks did well, an S&P 500 index would make some money because it would presumably own pharmaceutical stocks.

Drawbacks to Indexed Investments

An indexed investment gives you little or no control over how the money is spent. Hands on investors may not like this. Other people may object to the strategy because the index might contain stocks in companies they would object to. A pacifist might object to holding stock in a weapons company.

Another problem is that index funds can be very vulnerable to bull markets. If the market loses value the fund will. A large market sell off can significantly lower an index’s value.

An index is a long term investment tool that will only work if funds are left in for a long time. If you plan to take the money out quickly the gains from indexing will not be realized. That is why an indexed investment is ideal for retirement but not for short term savings.

Advantages to Indexed Investments

A big advantage to an indexed product is that you have to pay little or no attention to it. The fund’s managers will decide what to buy and when to buy. This can limit risks even if it makes the investing rather dull.

An S&P 100 fund would only invest in companies of a certain size. That would provide a certain level of safety because it the companies are proven money makers with considerable assets. It would avoid smaller newer firms that are riskier. It would also only buy into a company when it was a success or at a certain size.

This allows a person to invest in all the businesses that are performing well. It also avoids speculation and encourages disciplined investment.

A final advantage to indexed investing is that there some insured indexed products available. Some of these including indexed annuities are designed to lock in market gains. They have an insured rate of return that matches the highest index gain.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Ordinary Annuity, Retirement Annuity, and Income Annuity.

What is Technical Analysis

Filed under: Investing — Tags: , , , , , , — thefranksteak @ 12:28 pm

Technical analysis is one of two major schools of thought of investing popular today. Technical analysts believe that they can predict investment performance by analyzing statistical data about past market activity.

The major goal of technical analysis is to create charts, mathematical formulas or computer algorithms will show future market performance. The main belief behind this is that the market follows similar patterns that will repeat themselves. Statistics can be used to identify those patterns and predict future market performance.

When you see advertisements for gimmicks such as trading robots you are seeing ads for technical analysis tools. People pay money for such things because they believe they will enable them to predict market behavior.

Efficient Market Theory

Technical analysts often believe in what is called efficient or rational market theory. That is the belief that markets always operate in a rational manner and will always properly price everything correctly. In other words the market price is always the right price.

Value investors (the other major school of investment thought) think that the market is irrational and often overprices or undervalues investments. A technical analyst only looks at the market data available for an investment. A value investor looks at the market data and the fundamentals such as the amount of cash a company has in the bank.

Technical Analysis and Speculation

Many value investors would argue that technical analysis is not an investment tool. Instead they would argue it is a speculation tool. Many day traders and high volume traders use technical analysis in an attempt to bet on future prices.

They believe that they can use statistics to figure out when they can sell an investment for the best price. This is called market timing and it is the thinking behind trading bots and many other technical analysis tools. The charts and computer programs are supposed to tell a trader when to sell or buy. Many people who follow them end up losing all their money because the strategy did not work out.

Critics of technical analysis contend that market statistics only show part of the picture. A company’s stock price and trading value will not show what its sales are or how much money it is making. High trading volume can mask other problems such as huge amounts of debts. In the past many stocks that were market favorites collapsed completely. Other factors that will affect the investment’s long term price are ignored.

Technical Analysis and Investment

Technical analysis is not a good strategy for average investors because it was designed for speculation not investment. Most strategies involving it are designed for high volume traders that want to make a quick profit. Persons investing for the long haul will not profit from regular buying and selling.

A major draw back to this analysis is that it often necessitates frequent buying and selling of investments. This cost the investor money in the form of brokerage fees and commissions. It is why brokerages encourage technical analysis and often give away free TA tools or programs. They want you to engage in it so you will trade more and pay more fees.

The average person should follow other strategies such as modern portfolio theory or value investing. These may not be as flashy but they will not cost you a fortune in brokerage fees.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Single Premium Immediate Annuities, What is an Annuity, and Current Annuity Rates.

What is Portfolio Theory

Filed under: Investing — Tags: , , , , , , — thefranksteak @ 12:24 pm

Portfolio theory or modern portfolio theory (MPT) is the belief that the risks inherent in investment can be reduced through systematic diversification. In simple English this means investing in several different instruments in order to avoid losing all of your money.

MPT investors believe that a mathematical formula that outlines a diversified portfolio that will eliminate almost all risks can be created. This notion was first advanced in 1952 by Nobel Prize winning economist Harry Markowitz. Markowitz was the first to advance the idea that investment decisions should be based upon everything in the portfolio rather than individual stocks or bonds.

The Efficient Frontier

Markowitz and two partners William Sharpe and Merton Miller (the three shared a Nobel Prize for Economics) set out to devise a “mathematics of diversification” that could be used to create effective portfolios. They created a mathematical model designed to show investors how to arrive at the “efficient frontier.”

The efficient frontier would be a portfolio that evenly balanced risk and reward. If one stock in the portfolio lost money that loss would be covered by gains in another. Most mutual funds today and many indexed investments are designed to use MPT to arrive at this state.

In a portfolio created with MPT all the investments meet the criteria of the mathematical formula used. If it works properly the super efficient portfolio would never lose money. This is also called efficient market theory or the idea that the market behaves in a rational or efficient manner so its fluctuations can be predicted with mathematical models.

Criticisms of Portfolio Theory

Portfolio and efficient market theory have been heavily criticized over the years. Value investors such as Benjamin Graham and Warren Buffett believe that the market is irrational so its behavior cannot be predicted. Instead they believe that each investment must be judged on its fundamental or intrinsic value.

Another criticism is that the portfolio theory cannot take every risk or probability into account. There is simply no way that analysts can predict every event or development that could affect the market or an investment’s behavior.

Philosopher and hedge fund trader Nassim Nicholas Taleb believes that extraordinary events that affect the market are common place. Taleb thinks that no risk management model based on a prediction of a steady or efficiently working market is valid.
Taleb’s belief is that game changing events called Black Swans are more common than people think. These events can upset everything including the market so no risk management model based on a steady market can work. Under this theory a portfolio might operate efficiently for awhile but sooner or later some outside factor would upset its operation.

Taleb created the phrase Black Swans to describe highly improbable events that can disrupt everything. Such events can cause the entire market to collapse or lose value. Taleb reportedly made large amounts of money by betting against the market during the economic meltdown of 2005-2010. Many of the investments including 401Ks and mutual funds that lost a large amount of their value during this period were based on Modern Portfolio Theory.

Is It Valid

The book is still out on modern portfolio theory. The idea behind it is a sound one but its performance in the actual market has not lived up to some of the claims for it. Investors should definitely diversify their portfolios but they should also realize that diversification will not eliminate all risks. Instead it simply reduces the risks by making them less likely.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Annuity Definition, Annuity Rate, and Best Annuity Rates.

What is Value Investing

Filed under: Investing — Tags: , , , , , — thefranksteak @ 11:31 am

Value investing is the belief that you should determine the intrinsic or actual value of an instrument before you purchase it. A value investor bases her stock picks on the value of the underlying assets and current profits rather than the potential profits.

The Market is Irrational

The basic ideas behind modern value investment were invented by legendary investors Benjamin Graham and David Dodd in the 1920s and 30s. The basic ideas are that the market is irrational and investors must perform a fundamental analysis of stocks.

Graham believed that the market rarely sets the correct values for stocks. Instead he taught that the market was completely irrational and usually overvalues or undervalues investments. He actually compared what he called “Mr. Market” to a madman in some of his books.

Therefore, investors should look at the company that issues a stock rather than the market price. Graham taught that investors should always read the prospectus and earnings statements and carefully evaluate the company before purchasing. Graham insisted that this would allow you to buy stocks at less than their real value because the market often undervalues good companies.

Fundamental Analysis

Graham laid his ideas out in the books The Intelligent Investor and Security Analysis (coauthored with Dodd). One of his most successful pupils is Warren Buffett. Buffett’s approach is to seek out undervalued companies and purchase them. Buffett’s approach is based on fundamental analysis.

A value investor looks at a company’s fundamentals before spending her money. She looks to see if the company is making or losing money, if it has a large amount of outstanding debt, if it has a large market and if it is generating cash. A value investor would favor a stable company with a proven product and large sales over a startup with huge potential.

That’s why Buffett bought Coca-Cola stock rather than technology stocks in the 1980s. Coke was selling a product and making money everyday, many of the tech companies did not make money for years.

Value investors focus on how an investment is performing right now rather than how much it could make in the future. They will not put money into companies that are not making money no matter what their potential is.

Graham’s Formula and the Margin of Safety

Another thing that a value investor will insist upon is the margin of safety. That is why they invest in companies with large cash reserves. Such firms will be less likely to borrow to cover costs or expenses. Value investors stay away from any company that has a lot of outstanding debt for the same reason.

Graham also devised a formula that most value investors use: he taught that a company’s true value is based upon intrinsic value and current earnings. Any decision to purchase a vehicle must be based up on its present value and the money it is making right now. Projections of future earnings must always be ignored when making investment decisions.

Value Investing and You

Value investing is a very good basic investment strategy with a proven track record. Unfortunately the investment industry is not very fond of it.

The reason for this is simple, value investors like to buy and hold. Brokerages and traders make their money on commissions on stock and other sales. They prefer it when people speculate or actively trade. They make money when you sell and you buy, not when an investment sits there.

Value investing would be an excellent strategy for somebody investing for retirement to follow. Picking out a few good safe investments and holding onto them is the best way to make and keep money. Unfortunately it is not exciting so both the financial media and the investment industry work to discourage this type of investing.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Annuity Calculator, Annuity Interest Rates, and Annuities Good or Bad.

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