from Amazon
Tuesday, December 16, 2008
Madoff’s Ponzi
Non-sports post.
The millionaires are lying.
Suppose you were to buy a bond that returns 15% a year. Suppose you buy a bond that returns 7.5% a year. Which one will give you more money. It’s a trick question, because the answer is: the same. (Well, the 15% one will return a tiny bit more. But, that’s not the main point here.)
How is that? Because no bond is guaranteed. They each have their risks, and the more risk, the more you demand a return for your money. It’s really that simple. The market prices the returns based on these risks. And how can 15% match 7.5%? Because some will default at some point: they won’t pay out.
So, when a money manager guarantees you 15% a year, and all he wants is a one million$ buy-in, this is what happens for the next 20 years: you will get 150,000$ sent to you as a dividend every year. And in 20 years, you will have 3 million$ in dividends. You also have a “statement” that says you have 1 million$ in assets.
If on the other hand you went with a safer 7.5% a year, you’ll have 1.5 million$ in dividends. You also have a “statement” that says you have 1 million$ in assets.
That paper statement is worth more with the money manager offering you that 7.5% bond than the one paying you 15%. Because, there’s a higher chance that the latter is going to default, making that paper statement almost worthless.
So, say that 15% money manager defaults. What are you left with? Well, you have, in hand, your 3 million$ in dividends, and that paper statement worth (now) zero dollars, for a total of… 3 million$.
With the 7.5% money manager, you’ve got 1.5 million$ in dividens, and a paper statement that he will exchange for cash straight up, for 1 million$, for a total of 2.5 million$.
Who is better off after 20 years?
Before those millionaires start crying about how much they “lost”, ask them how much they actually earned through the years. If they were unlucky enough to reinvest their dividends into the same instrument, well, that’s another story.
But, billions of dollars simply don’t vanish. Madoff paid off in dividends. You have to include that in your calculations. The amount of money lost is actually equal to whatever it is that Madoff earned in compensation, and whatever he paid out to his employees and his other business costs. Whatever those costs are is tiny compared to whatever the newsmedia is reporting.
Unless Madoff embezzled as well. In that case, the money is not lost, but hidden. Unless he spent it, in which case it is lost.
If there is any news media reporting the issue as I am, please post links.