A Pyramid Scheme Would Never Have Worked for Madoff

You've probably heard about the Bernard Madoff investment scandal, in which investors were fleeced of $50 billion. It has resulted in at least one investor committing suicide and just today Madoff agreed to submit a list of assets, liabilities and property to the SEC and we may finally have visibility to the extent of his fraud.

I've noticed that the press seems to use the term "Ponzi Scheme" and "Pyramid Scheme" interchangeably, though the two are different in concept.

According to wikipedia the differences are that:

• In a Ponzi scheme, the schemer acts as a "hub" for the victims, interacting with all of them directly. In a multilevel scheme, those who recruit additional participants benefit directly (in fact, failure to recruit typically means no investment return).
• A Ponzi scheme claims to rely on some esoteric investment approach, insider connections, etc., and often attracts well-to-do investors; multilevel schemes explicitly claim that new money will be the source of payout for the initial investments.
• A multilevel scheme is bound to collapse a lot faster, due to the necessity of exponential increases in participants to sustain it. By contrast, Ponzi schemes can survive simply by persuading most existing participants to "reinvest" their money, with a relatively small number of new participants.

Based on these differences, we can see that a pyramid scheme would never have worked for Madoff:

• By definition, hedge funds require an element of faith on the part of the investors since the hedge funds managers do not fully disclose the details of their investments - ostensibly it is the secret sauce that others could quickly duplicate and dilute the value of the opportunity. In other words, it's easy to setup a hedge fund, and the challenge lies in getting someone to invest in it. It was the respectable Bernie Madoff acting as the Ponzi scheme "hub" that lulled investors into a false sense of security
• A pyramid scheme would have collapsed or been flagged by the authorities before reaching the size that the Madoff fund had attained. I'm willing to bet that a large portion of the $50 billion comes from initial investors who reinvested their money in the fund. Furthermore, institutional investors wouldn't touch an investment that is explicitly based on "new money."
  

Further reading:
The NPR: Planet Money has two podcasts that address the topic
The inital article that I read when Madoff was first charged
A primer on Ponzi schemes and the Madoff scandal from the Guardian

Inappropriate uses of the term "Pyramid Scheme" in the press:
JSOnline
Washington Post
The Economist

Hello World!

Welcome to my blog and the first of what I hope to be many posts.

First thing that I'd like to do is to thank my sisters in law (or is it sister in laws?) - Katrina (http://www.katrinaschaman.com/) for designing the template for my blog and Jessika for (http://dimsumsimon.blogspot.com/) helping me overcome my initial inertia by starting her own blog over the Christmas break.

Recognizing that the Tubes are clogged with a multitude of inane rants and ramblings, my goals for this blog are:

1. To serve as a forum for me to express my opinions. I believe that good opinions are an art form that can only be honed through practice. And while I don't imagine anyone will read this blog, I'm hoping that eventually this blog will engage me in discussions with people I wouldn't ordinarily meet.
   
2. To help bring structure to the content that I find interesting on the Interwebs. In my day-to-day work as a management consultant, I have to deal with vast amounts of data and ambiguity and distill it to a set of clear and actionable recommendations. I'll bring a similar approach to help clear the FUD (fear, uncertainty and doubt) propagated throughout the Webernet
   
3. To serve as a repository of thoughts and activities so that I can eventually retrospectively examine how my thoughts have evolved over time. Over time I'll also add my resume, links to Facebook, Twitter and Flickr, and eventually a podcast.
   

Signing off to work on my first post,
Irwin