Hidden amongst the
headlines celebrating ever-higher markets was the arrest of
Florian Homm, a German hedge fund manager on the run for
five years. He is accused of cross trading shares of stocks between his
company's funds, which boosted their value. This in turn generated more fees
for his firm and artificially increased the value of its shares. Of course,
the world of finance isn't the only place to find crooks. No profession is
safe. From unethical plagiarists to artists reproducing forgeries to doctors
scamming insurance companies, if you live long enough, you will see it all.
Nonetheless, it's hard to
ignore that there is a steady stream of crooks in the financial news. It
seems that almost every few months some new, small-time Bernie Madoff is
busted for one thing or another. What gives? Often the blame falls on
"greedy businessmen," but in my opinion, there are intrinsic
problems in the asset-management industry that helps crooks thrive:
1. You can make a
fortune by simply being lucky. Asset management is one of the only
industries where you can become a multimillionaire simply through luck. This
is a statistically provable fact. If you track the investment performance of
10,000 people who know nothing about stocks and trading, some of them will
become millionaires by sheer dumb luck.
Worse, those lucky
winners will typically convince themselves that they have some sort of
special insight. Hence, they will sound genuine when selling their investment
ideas.
There's no other
profession like this. For example, one can't be a lucky brain surgeon. If one
is a complete quack who learned nothing in medical school, one will
inevitably kill somebody and get booted from the profession. You can't just
get lucky from surgery to surgery. As a result, in other professions, the bad
apples are weeded out fairly quickly. However, in the financial sector, it's
quite possible for someone to be a multimillionaire and a complete imbecile
when it comes to finance.
From the pool of lucky
winners, you have the perfect combination to breed deception: access to lots
of money; a track record of success; and an inability to actually earn
returns through skill. Managers who earned their money don't need to cheat
their clients. But unfortunately, lady luck opens the industry's door to the
incompetent, who may become crooks when the luck runs out.
2. Rising waters
lift all ships. Sure, you can make a fortune in the stock market
simply by luck. But why make a fortune when you can also do well by doing
just good enough? In a rising market, one can almost pick any random stock
and do pretty well – maybe a few points more than the market or maybe a few
points below the market. One could know very little about the stock market
and make some random picks, and do all right at the least.
Rising markets help
protect fraud from being revealed. Since nearly everyone is making money, the
industry competition fails to eliminate the incompetent and the fraudulent.
Notice that most crooks are exposed when the markets turn sour. That
condition is part of the reason – it's much easier to run a scam in favorable
markets. If you're a very likable con man and promoter, you can attract a lot
of people to your fund while letting the market do most of the work for you.
One can be very good at raising funds and talentless at stock picking and
still eke out an incredibly good living in this business. But once things hit
the fan, raising money becomes impossible, and stock
picking and making wise moves turns out to be what matters.
What's most likely is
some combination of items one and two. Statistically speaking, it's difficult
to get lucky nonstop. But how about having a few really good years followed
by a bunch of average ones? On Wall Street, one can make a whole career of
doing precisely that.
3. As long as
there's money flowing, most investors are completely blind. A friend
of mine recently got into a horrible business deal that went wrong. To make a
long story short, there is fraud, courts, lawyers, and missing money
involved. How did he get into this bad deal? Essentially, the same guy made
him nearly a million dollars in a previous deal, which was an almost 300%
return. At the time, I had pointed out to my friend improprieties in the
relationship. Instead of making a million, he should have made $1.3 million
were it not for some dumb and questionable mistakes by his partner.
Of course, my friend
would not listen to me. His partner had just made him a million dollars –
that's all he needed to know. So even though I plainly showed him his
partner's incompetence and reliance on luck, he went ahead on a second deal
with him. In hindsight, his partner was doing fine in a rapidly rising market
that helped disguise his fraud and cluelessness. When the market crashed on
the next deal, everything came out of the woodwork. If someone is making us
good money, many people couldn't care less about the specific operational
details or the strategy. Such indifference to red flags is the dream of a
financial crook.
4. People forget
every lesson taught in business school. If someone is making money
or has previously earned money in the past, it's easier to ignore everything
learned in business school finance courses. Similar to item number three, we
are willing to believe anything from a wealthy person. "So you doodle lines on a chart of the S&P 500, and you can
predict the way the market is heading. Sounds kind of fishy… but since you
have so much money, I guess it must work."
I find it shocking how
many stock pickers out there just say off-the-wall, wacky stuff that would
get them an F in any finance course. Again, this happens in no other
profession. If you asked a surgeon to find a kidney and he pointed to the
heart, most of our jaws would drop in shock. In finance, the response
depends. If he's a rich hedge fund manager, he could convince investors based
on his wealth and past track record that a "heart" really is a
"kidney." Not only would many fall for such an incredulous
statement, but some would actually place him on a pedestal for his
unconventional "analysis" and deep "insight." This
sort of thing happens all
the time.
These four elements help
fraud go a lot further than in most professions. And it's hard for us to
resist some of these scams. How many people will look into the details and
fire an asset manager who just earned them 75% returns, when maybe the return
should have been 80%? Who can stand up to a super-wealthy fund manager and
accuse him of being a charlatan based on financial theory? This is exactly
happened with the Bernie Madoff scandal, as his consistent returns were
practically impossible. The case was laid out in front of the SEC. Nobody
listened – after all, Bernie was a super-successful investor.
It can be hard for
investors to defend themselves, especially because we judge other professions
similarly. You go to a doctor with a good reputation for helping patients;
you don't assume that he was lucky. But in finance, someone with a good
reputation might – believe or not – just be lucky, or worse yet, fraudulent.
My advice for avoiding
many problems is simple: don't focus on someone's net worth for your
investment decisions. Instead, consider their ideas and pretend that you
heard them from the intern just starting his first day on the job. Does the
idea still sound like a logical and reasonable investment plan? If so, then
you should go for it; but if you're following advice on blind faith, you're
potentially setting yourself up for disaster.
