What Ponzi Schemes Can Teach Investors

New research into the spread of Ponzi scheme frauds has suggested several social factors that lead to poor investment decisions.

Ville Rantala, of the Aalto University School of Business in Helsinki, Finland, looked into the spread of the WinCapita Ponzi scheme, which grew in Finland between 2003 and 2008, in his paper “How Do Investment Ideas Spread through Social Interaction? Evidence from a Ponzi Scheme”.

“A few powerful individuals with many social connections can significantly facilitate the epidemic spreading of contagious ideas.”He found evidence that older, wealthier investors are more likely to influence more people to join, and suggested that investors prefer to assess their trust in the person recommending an investment, rather than the investment itself.

“The findings suggest that social network structures play an important role in the spreading of investment ideas,” Rantala wrote, “and few powerful individuals with many social connections can significantly facilitate the epidemic spreading of contagious ideas.”

Likening the growth of Ponzi schemes to the spread of diseases, Rantala explained that any investor with a large social network was both more likely to be roped in, and more likely to pass a recommendation on to others.

“Although investors’ social learning can produce welfare-improving outcomes in many situations—e.g. through higher stock market participation and better portfolio diversification—the evidence of this paper indicates that it can also spread and exacerbate investment mistakes,” Rantala said.

The author also suggested that investors could make themselves susceptible to poor decisions by “question substitution”.

“In the case of Wincapita, some investors may have exchanged the more complex question ‘Do I trust this investment scheme?’ to the simpler question ‘Do I trust the person who is telling me about this investment scheme?’” Rantala said.

WinCapita was set up by Hannu Kailajärvi in 2003, purporting to make profits from sports betting and, latterly, currency trading. The scheme had €100 million of investors’ cash on its books when it was shut down in 2008. Rantala said 10,000 people invested in total, roughly 0.2% of Finland’s population.

The full research paper is available for download here.

Related Content: Five for Five—Bernie Madoff