There are many ways in which individual investors can get scammed within the financial industry. Some of these scams are well-known. Consider the classic pump and dump.
You join a stock picking “community” and the people running it recommend a stock. You buy it and the price goes up. Seeing such a quick return, you buy more. Then, all of a sudden, it crashes and you lose everything. Unbeknownst to you, the people running the community sold their shares (to you) and got out on the way up.
But, there are also those scams that are less well-known. These are what I’m going to be discussing today. Because it’s very easy to deceive in the world of financial services and I’ve seen just about every trick in the book.
To begin, let’s look at when outperformance isn’t really outperformance.
You Outperformed Then, But How About Now?
One way that active asset managers can deceive individual investors is by using historical performance charts. There is nothing wrong with historical performance charts themselves, but if you don’t use them properly, you could misadvertise your actual results. In some cases, a historical performance chart can show continued outperformance even when that outperformance no longer exists.
Benn Eifert recently tweeted an example of this as an investment brain teaser (see below):
Exercise for the group: your boss shows you this chart and says, “hey shouldn’t we be selling 10% OTM 1-month calls on all our stocks, won’t we get higher total returns?” What’s the problem with his reasoning?
Think about Benn’s question for a few seconds before reading my take below.
The core problem with this reasoning is that the performance chart above uses a linear scale on the y-axis. And, unfortunately, a linear scale won’t accurately show relative performance differences over time. In fact, such a scale can make it seem like the performance gap is growing over time even when the strategies are performing the same!
Run the following thought experiment and you will see what I mean. From the last point on the chart above give each strategy a 100x return (no relative difference in performance) over the next 40 years. If you did this, the OTM strategy would have a final value of ~$154k and the S&P one would have a final value of ~$107k.
Visually it will look like there is a growing divergence in performance between these two strategies though we know that this can’t be the case. Their relative performance is the same (they both went up 100x), yet it looks like one is outperforming the other. What gives? The visual divergence is merely an artifact of a prior period of outperformance.
In this case, the prior period of outperformance occurred from 2000-2012. During that period the OTM strategy outperformed the S&P only strategy, but since then, the OTM strategy has actually underperformed slightly. Unfortunately, it’s difficult to figure this out simply by looking at the chart above.
How do you fix this issue? There are a few options:
- You can use a log scale on the y-axis.
- This would make all percentage changes similar in magnitude across time so you could better visualize relative differences in performance.
- You could examine different individual performance periods.
- Instead of looking at performance over time, break the performance into separate periods.
- You could look at rolling performance.
- Instead of breaking performance into a few distinct periods, you can look at the rolling performance difference between these two strategies. This will let you see how each has performed relative to the other over time.
Whatever option you choose, these will provide a clearer picture of what you are investing in and whether the strategy being advertised still outperforms over time.
Unfortunately, even when you do have the right performance data, sometimes there is more hiding behind the scenes.
Cherry-Picking Your Alpha
One of my other favorite investment scams is called The Baltimore Stockbroker and it goes something like this:
It’s Sunday morning. You walk to your mailbox and see a letter from a mysterious stock research firm. The firm claims that their market insights team knows with 100% certainty that a particular stock is going up over the next week. Skeptical, you put the envelope aside and go about your day.
One week later you receive another letter from the same firm, but this time they claim a different stock is about to drop in price. You go back to the first letter, and, lo and behold, they were right. The stock went up. Your interest is piqued.
Over the course of the next week you watch the stock from the second letter drop as predicted. Now you are hooked.
Week after week, letter after letter, the firm continues to reveal the future of a single stock as if reading from a crystal ball. After 10 weeks of correct predictions, you get a final letter asking you to invest money with them for a sizable commission.
You calculate the probability that they could get 10 positive/negative calls correct in a row is 1/1,024 (or 2^10). This can’t be chance, right? You decide to pull the trigger and invest with them. Months later you are broke after the firm fails to repeat their prior success. What went wrong?
The scam here is that you weren’t the only individual to receive letters from the research firm. In fact, in the first week, letters were sent to 10,240 people (including you). Half of these letters (5,120) predicted that stock A would rise, while the other half (5,120) predicted that stock A would fall.
The 5,120 individuals that received the letter saying stock A would rise (the correct group), received a second mailing in the following week. Half of these “week 2” letters (2,560) stated that stock B would rise, while half (2,560) stated that stock B would drop.
This process continued each week with those individuals who received correct calls getting additional mailings. After 10 weeks of this, there are exactly 10 individuals who received 10 correct calls in a row (1/1,024 * 10,240) completely by chance. You happen to be one of those lucky (or shall I say unlucky?) individuals.
No matter how you look at it, this scam relies on survivorship bias, or what I like to call cherry-picking your alpha. There are many ways someone can cherry-pick alpha too. They could make a lot of stock picks or test a lot of different investment strategies, but then only advertise the ones that did well. Of course they have to hide all (or most) of their failures. If they didn’t, then people might realize that they aren’t as skilled as they claim to be.
How do you fight against alpha cherry-pickers? It’s not easy, but here’s what I would do:
- Ask to see their losing calls
- See how willing they are to show you their losing strategies or ideas. Even successful stock pickers will have loads of bad calls. If they don’t, they’re probably lying to you.
- Audit their performance
- If they aren’t willing to share their underlying performance data for you to have a look at or they don’t have it available, that’s a red flag. And if they do provide it, look it over for any irregularities. This is not my area of expertise, but I know that there are ways to use simple mathematics to see if certain data series might be manipulated (see Benford’s law).
- Wait them out
- If the person you are talking with actually has such a great strategy, then it should continue to outperform in the future. Just wait a while and see if it does. While this strategy is risky as they could get lucky while waiting, there’s at least a chance that the truth is revealed while you wait them out.
Overall, “cherry-picking your alpha” is a difficult scam to identify because, by definition, the truth is hidden from you. But if you ask enough questions, then you might be able to figure out what’s going on.
And of all the questions you should ask when evaluating a new investment, “Where’s the return coming from?” might be the most important.
Where’s the Return Coming From?
Investments come in many forms, but they all share one thing in common—they are supposed to generate a return. Some seek to generate a large return. Others just want a consistent return. Either way, the goal is some future payout on your money.
No matter what you are investing in, you should have an idea of how this payout is generated. For some investments, the payout is based on what are other people are willing to pay for. This is true for things like art, wine, gold, and cryptocurrency. You only make a return in these if someone else buys the thing from you at a higher price.
Then, there are those assets whose return is based on its future cashflows. This is true for things like stocks, bonds, private businesses, and real estate. Of course, what other people are willing to pay for these things matter as well, but, in theory, the cashflows should act as a guide on such valuations.
But then there are those investments that advertise that the return comes from one source, when its actually another. The poster child of this is yield farming within cryptocurrency. The idea was that by lending your cryptocurrency to others (i.e. staking) you could earn 20% per year (or more) even while U.S. Treasury Bills were paying nowhere near that rate.
Of course, those who did this for a long time found out otherwise. As the saying goes:
If you don’t know where the yield is coming from, you are the yield.
This is true of Ponzi schemes, like the one run by Bernie Madoff, and many other scams perpetrated on individual investors. If you can’t spell out exactly how something makes you money, then you shouldn’t be investing in it. Period. If you can, then you have a chance at avoiding the sharks of the financial industry.
The Bottom Line (Free Lunches are Rare)
The financial world is not always a friendly place. Unfortunately, there are those out there that will tell you anything to take your money. And while I can tell you about the many different scams I’ve heard of throughout history, scammers will always find new ways to deceive you.
Therefore, if there is one rule I’d abide by to avoid getting scammed in the investment world it’s this—free lunches are rare. In economics they teach us that “there is no such thing as free lunch.” In other words, everything has a cost.
This is true almost all of the time in investing as well. You don’t get something for nothing. If you want great returns, you generally have to take great risks. And though exceptions to this “rule” exist, they are incredibly rare.
So if you find yourself being presented with an “opportunity” to get rich quick, it’s almost certainly not the case. That lunch probably isn’t free.
If you follow this advice, you will definitely miss out on some incredible opportunities. However, you are less likely to get scammed as well.
Whatever you decide to do, stay safe out there. Happy investing and thank you for reading!
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This is post 440. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data
