Financial charlatanism is unfortunately very common in the financial industry despite many laws aimed at preventing it. This is probably because finance is about money, and money tends to attract fraudulent people who try to profit from some sort of scam.
As CEO of Portfolio Inc, you need to be keenly aware of this reality and have a plan to ensure you don’t get caught in these things.
Of course there are the obvious scams. Here, I’m referring to those brochures you get in the mail claiming that you can make 143% in 18 months by investing in penny stocks. The true value of these is to help light up your fireplace in the winter, especially now that newspapers are out of fashion. I’ll admit I get my share of these things in the mail and they help me make nice fires during cold winter days. But I digress.
Concealed Financial Charlatanism
The true danger we face as investors is what I call “concealed financial charlatanism”. These are the claims that generally look very real, and may in fact be promoted without any bad intentions.
There are many ways in which claims can be overly optimistic while hiding some ugly truths. One common way is by selecting assets that have done well after the fact. Here’s a conceptual example.
Mr. Charlatan wants to sell you a stock investment strategy. That strategy is designed to pick the “best stock” within a universe of 50 stocks that he regularly follows. Let’s assume for now the strategy has merits. The core issue is which 50 stocks has Mr. Charlatan picked to make up the universe he follows. If each of these stocks happened to have done especially well over the past 5 years, then it’s only natural that any strategy (even a random strategy) will do well. There is no need for the strategy to have skill because any pick will do well. The real issue is that Mr. Charlatan picked the universe AFTER learning how these stocks have performed. If he had selected the universe 5 years ago, before the outperformance, it’s likely that some companies may have gone bankrupt, most stocks would have stalled or gone nowhere while perhaps only a handful would have done really well.
A sensible strategy should use the entire universe of stocks available to any investor at the time of selection and then pick the best stock at that time. Any other way is a form of cheating.
You must also remember that any self-respecting investment strategy should always be compared against its investment universe. If it’s a good strategy, it should do better than the average of the universe, all else considered. So next time you meet Mr. Charlatan, start the conversation by asking these key questions:
- When did you select the assets making up the universe? That date should be your starting point to evaluate the strategy.
- How has the strategy’s universe performed on average since you selected it?
- Is the strategy adding value vs. the average pick on the universe?
- What if the strategy is applied to a different investment universe? Will it also perform well?
Survivorship Financial Charlatanism
Another way to mislead investors is by using what is commonly known as survivorship bias. This can take many forms, and unfortunately it is pervasive in finance. It’s also a common way for even the most reputable mutual fund companies to showcase funds that have performed well in the past. Here’s a simple example of how it’s done:
A mutual fund company decides to start 12 new funds, each managed by a different manager, and each following a different strategy. They promote each fund over the years and get investors to jump in. So far so good.
A few years later, the management company notices that one fund has done particularly well, whereas the others have been mediocre. So they decide to shut down the 11 underperforming funds and roll their assets over into the better fund. Investors are generally happy because they get rid of a “bad investment” and their money is moved to a presumably “good investment”.
But is the better fund really using a better strategy, or was it just lucky compared with the other 11 funds?
The fact is, the better fund could just have been lucky during that time frame compared to the 11 others. It’s quite possible (and, in fact, likely) that this out-performance will not be sustained in the future.
When they launched the 12 funds, the fund company essentially rolled the dice 12 times. They were hoping that one of these rolls would produce all sixes – in other words, an excellent performance. Since each fund used a different strategy and manager, it was also very likely that each fund would NOT get the same performance results. Some would do bad, some just okay, and maybe one or two would do really well. That’s just how randomness works.
So after a few years, the fund company can easily pick the fund that did the best with the benefit of hindsight and shut down all the others.
What’s worse is they have no legal requirement to report performance on a defunct fund once it is shut down. So by doing this repeatedly, they essentially inflate the average performance of their surviving funds – since the ones reported are only the best ones. But the average investor hasn’t done so well. A good number of them were moved to the best fund AFTER it has performed well, while in reality they got poor returns from a fund that is now defunct.
Surviving Survivorship Bias
Unfortunately, survivorship bias is pervasive in finance. It is also a challenge for an investor to escape this phenomenon. However, it helps to insist on a few key questions when considering investing in a fund or a strategy:
- How long has the fund/strategy been available to investors?
- What has been its performance since inception? The longer the history, the less likely its performance was caused by random luck.
- How has it performed against its investment universe?
- When comparing fund performance, its universe is the only appropriate benchmark. For example, use a real estate index to compare the performance of a real estate fund.
- Naturally, always look at performance in the context of risk. One way to do this is to look at risk adjusted returns using the Sharpe ratio.