Friday, August 18, 2006

The Pyramid or Ponzi Scheme and the Positive Feedback Loop

As some of you would have guessed after reading the previous post, a bubble is very much similar to a Pyramid Scheme or Ponzi Scheme. These are essentially elaborated setup that promise riches to those who join but are bound to fail because they are not based on fundamentally sound economics.

*Pls google those bombastic terms if you are still blur, confused, wondering what the heck pyramids in Egypt have to with do soap bubbles or thinking that Ponzi was a disciple of Sun Zi, the great military strategist in China 2,000 years ago. If you did, don't worry, I thought Ponzi was a disciple of Confucius or Kong Zi*

A Pyramid Scheme or Ponzi Scheme (also exhibited in other forms like Rat Society, MLM, etc) has two characteristics:

1) The person who joins have to cough up some amt of money
2) The person can recruit others to join under him, the recruits in turn cough up an amt and the person on top gets a cut

This scheme essentially benefits early birds as they are the ones who can enjoy more income as more and more people join. But it is bound to fail because it is not based on fundamental economic growth and no. of people who will join will eventually run out.

However at the start, the early birds usually enjoy some success. This is because as more people join them, they see money rolling in and they reaped back their initial investment. This is called the Positive Feedback Loop.

The success of the early birds convinced them and their friends that the scheme worked and they fervently recruit more people. This is what happens in stock bubbles. Early adopters buy stocks and see their wealth grow. They spread the word, more people join them. But since this is not based on real economic growth, at some point, there will be less buyers than sellers and everything collapses.

MLM is an ingenious way that masks a product into the Ponzi Scheme. The selling price is set ridiculously high to feed those at the top of the pyramid. But it is also bound to fail because there will be a point where you simply cannot get any more buyers to cough out those exorbitant rates for mildly useful health products, magnetic beds or the other shady products with unmeasurable usefulness.

The same goes for internet ads promising huge returns in days or weeks. It will only work if you are an early bird. Chances that you are an early bird is as good as finding a $10 bill in the middle of Orchard Road. (i.e. very low lah, bcos someone would have picked it up. But not impossible.)

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