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A Stock-Market Scam

The following four paragraphs are from John Allen Paulos' excellent book Innumeracy. The Stock-Market Scam is a classic numbers game illustrating how investors can be fooled into believing someone possesses predictive ability.

     Some would-be advisor puts a logo on some fancy stationery and sends out 32,000 letters to potential investors in a stock letter. The letters tell of his company's elaborate computer model, his financial expertise and inside contacts. In 16,000 of these letters he predicts the index will rise, and in the other 16,000 he predicts a decline. No matter whether the index rises or falls, a follow-up letter is sent, but only to the 16,000 people who initially received the correct "prediction." To 8,000 of them, a rise is predicted for the next week; to the other 8,000, a decline. Whatever happens now, 8,000 people will have received two correct predictions. Again, to those 8,000 people only, letters are sent concerning the index's performance the following week: 4,000 predicting a rise; 4,000 a decline. Whatever the outcome, 4,000 people have now received three straight correct predictions.

This is iterated a few more times, until 500 people have received six straight correct "predictions." These 500 people are now reminded of this and told that in order to continue to receive this valuable information for the seventh week they must each contribute $500. If they all pay, that's $250,000 for our advisor. If this is done knowingly and with intent to defraud, this is an illegal con game. Yet it's considered acceptable if it's done unknowingly by earnest but ignorant publishers of stock newsletters, or by practitioners of quack medicine, or by television evangelists. There's always enough random success to justify almost anything to someone who wants to believe.

There is another quite different problem exemplified by these stock-market forecasts and fanciful explanations of success. Since they're quite varied in format and often incomparable and very numerous, people can't act on all of them. The people who try their luck and don't fare well will generally be quiet about their experiences. But there'll always be some people who will do extremely well, and they will loudly swear to the efficacy of whatever system they've used. Other people will soon follow suit, and a fad will be born and thrive for a while despite its baselessness.

There is a strong general tendency to filter out the bad and the failed and to focus on the good and the successful. Casinos encourage this tendency by making sure that every quarter that's won in a slot machine causes lights to blink and makes its own little tinkle in the metal tray. Seeing all the lights and hearing all the tinkles, it's not hard to get the impression that everyone's winning. Losses or failures are silent. The same applies to well-publicized stock market killings vs. relatively invisible stock market ruinations, and to the faith healer who takes credit for an accidental improvement but will deny responsibility if, for example, he ministers to a blind man who then becomes lame.

Copyright 1988 John Allen Paulos. Reprinted with permission. (Bold added)

The scam analogy appears in numerous books in similar versions (including Martin Fridson's Investment Illusions) and can be relevant in many ways to investors. For instance, many mutual fund companies offer scores of mutual funds. The reality is that the more funds or products a company offers, the better the chances are that one of the funds will rank at the top of its category. The company can then focus its marketing efforts on those funds that have the best track records while keeping quiet about those that underperformed. In succeeding periods, other funds will perform well and then marketing efforts will shift to those funds.

An important lesson to learn from the scam is that in addition to evaluating individual products, investors should evaluate all of a firm's offerings. Additionally, it can be helpful and often quite illuminating to look at an individual's or firm's previous offerings that have since been eliminated or merged into other funds. An organization that has a history of introducing new products and then discontinuing some of those offerings may be playing the numbers game and should be evaluated with caution.

A further caveat for investors to consider is the question of whether past performance predicts future performance. There is a large body of evidence that successful funds from one period are no more likely to outperform in the following period than other funds.

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