A fool and his money: A lesson in investor behavior

Court jester hat

In honor of April Fools’ Day, this post covers one amusing investment scam that offers a very real lesson in investor behavior. It’s discussed in the book Innumeracy by John Allen Paulous. The plot of a 1957 Alfred Hitchcock movie called Mail Order Prophet revolves around a related scam that extends beyond the investment industry.

Here’s how it works.

A scammer picks a stock and mails a few thousand potential investors with his prediction of whether the stock will go up or down. The catch is that half of the people get a letter saying the stock will rise over the next month. The other half gets a letter saying it will fall. Sneaky.

The scammer’s next step is to take the group of potential investors who received the correct call and repeat the process with another stock. Although the group becomes small after a few rounds, he has a list of marks who have received a string of perfect stock predictions. If he convinces enough to invest based on that compelling track record, he can walk away with their money.

Lessons for investors

The obvious lesson, of course, is to never make an investment based on an unsolicited newsletter or a call from a boiler room salesperson. But a couple other lessons come to mind, too.

First, our brains work like this stock scam more than we might appreciate. Behavioral scientists describe this as choice-supportive bias. That’s a fancy label for our tendency to protect our self-image by conveniently forgetting past mistakes and remembering good choices. We do this when talking with others, we do this when talking to ourselves, and we’re rarely conscious of it.

Investing is fertile ground for this behavior. Have you ever had clients or prospects complain about your performance track record in a challenging market cycle (or maybe even a good one!) against a potential imaginary track record of their own keen investment prowess? If so, choice-supportive bias was likely at work. Confronting clients with this behavior may not be the wisest course of action. But knowing about this bias can bolster your confidence that they may not be as prescient as they might think—and help you tactfully address the issue.

Lessons for our industry

Two professors at Wake Forest University published a paper titled “Star Creation: The Incubation of Mutual Funds” that compares this classic investment scam with how mutual fund firms can potentially manufacture attractive performance histories.

With enough resources, a mutual fund firm could create and register a stable of new products with the SEC but not immediately market them. As time passes, some would appear to be winners and some losers. The firms could then aggressively market the winners and their attractive track records, which are based on luck instead of persistent investment expertise.

Of course at Russell, we don’t subscribe to this approach – it’s not the basis for a trusted relationship of long-term investing success focused on investors’ goals.

The bottom line

April Fools’ pranks can often be funny. But beware of those that aren’t – whether it’s April 1st or not. The same aspects of investor behavior that can make people susceptible to too-good-to-be-true investment opportunities can be just as dangerous when it comes to assessing performance or making decisions about staying invested and diversified.

You can play an important role in helping clients avoid these types of behavioral mistakes.

RFS 12501
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