Navigating the Investment Minefield

By H. Kent Baker and Vesa Puttonen

Fraudsters are always on the look out for prey – investors they can manipulate and take advantage of. The authors discuss 8 traps you should look out for in navigating through the investment minefield. After all, vulnerability, if not gullibility, and can be costly.

 

The investment world can be a scary place, especially given that some people want to take advantage of you by setting investment traps. A trap is something that can lead to losses of capital or opportunities to make productive investments. Given that many investment traps are difficult to detect, what chance do investors have navigating the investment minefield and emerging unscathed? The answer is not much unless they become aware of the traps that are strewn along their path and sidestep them. Although succumbing to such traps is unlikely to be fatal, it can seriously harm personal wealth, affect achieving financial goals, and damage self-esteem. Our purpose is to expose eight common investment traps so that you can avoid falling victim to them.

 

Trap 1. Becoming a Victim of Investment Fraud and Other Scams

Have you ever been a victim of investment fraud? If not, you probably know someone who has. The countless number of investment frauds, scams, cons, schemes, and swindles demonstrates how easily skilled fraudsters can dupe unsuspecting investors. In his book Swindling Billions: An Extraordinary History of the Great Money Fraudsters, Kari Nars estimates that fraud victims around the world have lost hundreds of billions of dollars in the last decade to investment fraud.1 Anyone with money is at risk of investment fraud. Even highly successful, financially intelligent people can fall prey to investment fraud. For example, Bernie Madoff’s infamous Ponzi scheme fooled thousands of individuals, including celebrities, as well as financial institutions and universities. A Ponzi scheme is a form of investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors.

People also have a psychological need to feel special. Fraudsters play upon this need by convincing them that they are part of an “exclusive club” and are being given special access to an investment opportunity.

Investors fall for scams for many reasons. Some people are gullible so fraudsters prey on their trusting nature. Other investors are irrational and driven by emotion, which makes them particularly susceptible to becoming victims of investment fraud. Because investors are attracted to financial gain, the lure of “get-rich-quick” schemes flames their innate desire to become financially better off. In an uncertain financial environment, investors often turn to others who appear or proclaim to be experts only to have these people take advantage of them. On other occasions, investors can be overly optimistic, which makes them more likely to be hoodwinked than others. People also have a psychological need to feel special. Fraudsters play upon this need by convincing them that they are part of an “exclusive club” and are being given special access to an investment opportunity. Finally, investors are more vulnerable when they believe they are knowledgeable. Although this sounds counterintuitive, those who have some experience in investing or believe they are experts are more susceptible to investment fraud than others. Such investors think they know more than they actually do or that they are too smart to fall for a scam.

To avoid being scammed, you should be aware of several major warning signs. One common warning sign is someone touting an investment with high guaranteed returns with little or no risk. Claims of huge gains with almost no risk are illusions or “phantom riches” for unsuspecting investors. All investments carry some degree of risk. Fraudsters dangle the prospects of easy money to entice you to buy. Investments that seem too good to be true probably are. Another red flag is an investment hyped as a “once-in-a-lifetime deal”. You should also be suspicious of claims that “everyone is buying” and resist pressure to buy quickly. No reputable investment professional should push you to make a quick decision. Although not applicable to all investments, you should be suspicious of investments, such as common stocks or equity mutual funds, providing consistently stable returns regardless of market conditions. Returns generally vary over time due to market volatility. A final warning sign concerns investments or strategies that are overly complex. If you don’t clearly understand the investment, walk or better run away.

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Trap 2. Misrepresenting Risky Products as Safe

Many investors are attracted to investments promising stable returns. This desire helps explain why so many “stable returns”, “capital guaranteed”, and “low volatility” products are available in financial markets. Although these descriptions may accurately describe some products, less scrupulous individuals or firms may misrepresent risky products as safe. Risky investments offer the potential of high returns but they also have a large chance of loss of capital or underperformance. As Robert Arnott, an American entrepreneur, investor, editor, and writer, notes, “In investing, what is comfortable is rarely profitable”. In most cases, you can’t eat your cake and have it too. Investments always involve risk-return trade-offs.  

Many examples are available around the world in which various parties have misrepresented risky products as being safe. Notable examples include mortgage-backed securities in the United States, preference shares in Spain, money market funds with floating rate notes in Finland, and Minibonds in Hong Kong. Let’s examine the case of Minibonds, which is a brand name for a series of structured financial notes. Using the term “bond” to describe these products is misleading but was intended to inspire confidence. The return paid by these structured products was linked to a basket of shares, a stock market index or the creditworthiness of various publicly-listed corporations. Both the return and the consumer’s original investment depended on the ability of the issuing investment bank to make the payments due under the structured product. Lehman Brothers was the investment bank. In total, more than 43,700 consumers bought HK $20.23 billion (US $2.6 billion) worth of Lehman Brothers structured products through retail banks. When Lehman Brothers collapsed in September 2008, the supposedly “low-risk” Minibonds generated huge losses for individual investors.

 

Trap 3. Making Unrealistic Return Expectations

Having unrealistic return expectations is a common investment trap. This is especially true of new or inexperienced investors who enter the market at a time of extreme exuberance because they become disillusioned when they start experiencing paper losses. The possibility of missing out on such high returns is simply too much to bear. However, investors, even professionals, are notoriously poor market timers. Greed and overoptimism have been the ruin of many investors. You would be wise to heed the warning provided by investment firms that “past performance does not guarantee future results”.

Investors need to be aware of several misconceptions that lead to making unrealistic return expectations. One fallacy is that a good company such as one that has experienced rapid growth in the recent past makes a good investment. In fact, shares of “good companies” may or may not turn out to be “good investments” by providing good returns. Although good companies might have generated excellent past returns, the current valuation should reflect all company features. Therefore, any good firm characteristic that is priced by the market is associated with lower, not higher, return expectations.

Another fallacy is that economic growth is good for stock returns. This misconception leads to the belief that investing in countries with strong economic growth such as emerging markets offers better returns to equity holders than countries with less vibrant economies. The faster growth is typically associated with stronger earnings growth, which many investors associate with higher expected stock returns. This misguided idea of excessive return expectations has been a major sales pitch for emerging market mutual funds. This growth trap seduces investors into overpaying for the equities in emerging markets. Empirical evidence on the link between economic growth and returns to shareholders shows that shrinking industries and slower-growing countries offer some of the best-performing investments.2

 

Trap 4. Falling for Mutual Fund Traps

Although mutual funds offer many advantages, some traps can snare unsuspecting investors. One common trap is investing in past winners. Mutual fund companies generally advertise their best-performing funds.3 This tactic creates a relatively one-sided image of the company’s offering of mutual funds and directs investor attention toward past performance reinforcing the habit of selecting mutual funds with the highest realised returns. For most investors, buying past winners is not a value enhancing strategy after expenses and fees. Top performers do not typically stay on top for very long. Thus, this year’s top funds can easily become next year’s duds. Still, research indicates that investors should avoid poorly performing funds because their performance may persist for many years due to high expenses and fees.4

Additionally, some conventional wisdom about investing in mutual funds lacks empirical support. For example, investors are often encouraged to buy established mutual funds with experienced portfolio managers that have good long-term track records. Although this might seem like sound advice, recent evidence shows that young actively managed funds tend to outperform their older peers because the new entrants are more aware of the latest techniques. Furthermore, performance tends to deteriorate as funds grow older. Researchers find that funds with three years or less in age actually outperform funds with more than 10 years of history by almost 1 percentage point annually.5 Thus, investing in younger, rather than older, funds may be less risky.

 

Trap 5. Overpaying for Products and Services

You’re probably familiar with the saying “you get what you pay for”. In commercial transactions, the quality of goods and services often increases as the price increases. That is, paying more can mean getting better quality merchandise. However, paying more for investment products and services does not necessarily lead to higher performance or returns.

A recent phenomenon in the mutual fund industry is closet indexing. Closet indexers are funds that closely track a benchmark while claiming to be active and charging fees similar to those of truly active managers. You can achieve a similar result by investing directly in a less expensive index fund. In some cases, funds become closet indexers as they grow in assets. This fact helps to explain why some superstar managers fail over time. Buyers should be wary of funds charging a fee for active management but whose performance barely varies from the index. Research shows that closet indexers are doomed to underperform after considering fees and that closet indexing is rife in US active funds.6 

A fund of funds (FOFs) is an investment strategy in which a fund invests in other types of funds. This strategy applies to any type of investment fund, from a mutual fund to a private equity fund to a hedge fund. In general, a FOF strategy tries to achieve broad diversification and appropriate asset allocation with investments in different fund categories. FOFs appeal especially to small investors who don’t want to invest directly in securities. A drawback is that investors basically pay double for an expense that is already included in the expense figures of the underlying funds.

 

Trap 6. Investing in Complex Products

Never invest in something you don’t understand. If you do, you are inviting disappointment. The amount and complexity of different kinds of investment products available in today’s markets can be overwhelming. The complexity of financial products has increased steadily, even after the financial crisis of 2007-2008, and is more prevalent among distributors with a less sophisticated investor base. Additionally, financial complexity increases when competition intensifies.

Never invest in something you don’t understand. If you do, you are inviting disappointment.

Although the typical investor should avoid investing in overly complex financial products, this may be easier said than done. Structured products have been a success story in retail finance. Low interest rates drove investors in search of structured products apart from traditional asset classes such as equities, fixed income, and real estate. Structured products tend to have complicated contract terms making the valuation of the product difficult for retail investors. Conditions can include different averaging methods for starting and ending values and caps limiting the maximum price increase of the underlying asset (e.g. stock index) in which the investor will participate. The proper valuation of these products requires complicated financial modelling, which results in the product-issuing financial institution having a clear information edge over its clients. Evidence shows that financial complexity in European markets has been steadily increasing. The more complex a retail structured product is, the more profitable it is for the bank.

 

Trap 7. Engaging in Gambling Disguised as Investing

According to some Wall Street skeptics, the stock market is the capitalist casino, a place where gambling wears a thin mask called investing. However, this cliché doesn’t adequately differentiate between gambling and investing and represents a misinformed view. Investing isn’t simply gambling by another name because gambling is a no-win venture whereas investing isn’t. Despite some superficial similarities between the two concepts, major differences exist between gambling and investing. The main difference is that an investor’s expected return is positive whereas a gambler’s expected return is negative. Two areas where gambling is disguised as investing, at least for individual investors, involve foreign exchange and excessive online trading.

Currency trading is a zero-sum game. This means that in FX trading, one’s win is always another’s loss. In fact when accounting for commissions and other expenses, FX trading becomes a negative-sum game. Online trading platforms targeted to unprofessional investors are gambling disguised as investing. After going online, investors tend to trade more actively, more speculatively, and less profitably than previously. Evidence shows that individual investors destroy value through active trading.

 

Trap 8. Relying on Unsupported Promises

Some financial products are sold using marketing claims unsupported by evidence. For example, long/short equity funds claim that they can provide a “free-lunch”. The phrase “there’s no such thing as a free lunch” is often used to describe situations in which investors are unable to consistently make large profits without bearing the risk of a potential loss. Other examples of unsupported promises involve investment letters and investment clubs.

This diverse market of newsletters consists of around 1,300 different newsletters in the United States and Canada with an annual industry revenue of more than $3.4 billion. These numbers indicate a clear demand for investment newsletters. Several studies on investment newsletter performance find that securities recommended by investment newsletters don’t outperform appropriate benchmarks and thus don’t generate positive abnormal returns. The media attention given to a few well-performing investment clubs created a public consensus that investment clubs tended to outperform the markets. Evidence suggests the opposite. One academic study denounces the widely suggested claims of general outperformance of the clubs. Of a sample of 166 investment clubs, 60% underperformed the market.7

 

Lessons Learned

Heeding the following lessons should reduce your chances of becoming a victim of investment traps.

Don’t let anyone talk you into buying a financial product you don’t fully understand. You may recall the admonition, “If something sounds too good to be true, it probably is.” Although this is good advice, the problem is determining when “good” becomes “too good”.

Don’t assume that laws in place will automatically protect you from any kind of foul play. You are responsible for checking the true content of the offering.

Do your due diligence and don’t simply rely on those making the claims. You should ask questions and keep a healthy sense of skepticism. If someone makes a questionable claim, ask for evidence. Being inclined to easily trust anyone who is trying to sell you something gives way to vulnerability, if not gullibility, and can be costly.

Check with relevant regulatory authorities for any complaints or investigations involving those offering the products.

Don’t assume that laws in place will automatically protect you from any kind of foul play. You are responsible for checking the true content of the offering. 

Don’t let greed overcome your good judgment. Although not speaking about investments, Stephen Hawking, an English theoretical physicist, cosmologist, and author, notes: “We are in danger of destroying ourselves by our greed and stupidity.” If your internal alarm bell rings, listen to it and find another investment. 

This article draws on some themes from the authors’ book Investment Traps Exposed  Navigating investor Mistakes and Behavioral Biases published by Emerald Publishing in 2017.

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About the Authors

H. Kent Baker, CFA, CMA is University Professor of Finance at American University’s Kogod School of Business in Washington, DC. He is the author or editor of 28 books and more than 165 refereed journal articles. The Journal of Finance Literature recognised him as among the top 1 percent of the most prolific authors in finance during the past 50 years. Professor Baker has consulting and training experience with more than 100 organisations. He has received many research, teaching and service awards including Teacher/Scholar of the Year at American University.

Vesa Puttonen is Professor of Finance at Aalto University School of Business in Helsinki.  He has published 16 books and more than 30 journal articles on different aspects of Strategic Finance, Risk Management, Behavioural Finance, and Investing. Professor Puttonen has worked as Senior Vice President at the Helsinki Stock Exchange and as Managing Director at Conventum Asset Management (Helsinki). He is a faculty member of MBA Programs in Helsinki, Hong Kong, Singapore, Poland, China, Iran, Taiwan, and South Korea.

References

1. Kari Nars. 2009. Swindling Billions: An Extraordinary History of the Great Money Fraudsters. London: Marshall Cavendish Business.
2. Jay R. Ritter. 2012. “Is Economic Growth Good for Investors?” Journal of Applied Corporate Finance 24 (3), 8 – 18.
3. Jonathan J. Koehler and Molly Mercer. 2009. “Selection Neglect in Mutual Fund Advertisements.” Management Science 55 (7), 1107-1121. Congsheng Wu. 2009. “Mutual Fund Advertisements.” Investment Management and Financial Innovations 6 (2), 68 – 76.
4. Matthew R. Morey. 2016. “Predicting Mutual Fund Performance.” In H. Kent Baker, Greg Filbeck, and Halil Kiymaz (eds.), Mutual Funds and Exchange-Traded Funds – Building Blocks for Investment Portfolios, 349 -363. Hoboken, NJ: John Wiley & Sons, Inc.
5. Lubos Pastor, Robert F. Stambaugh, and Lucian A. Taylor. 2014. “Scale and Skill of Active Management.” NBER Working Paper No. 19891. February.
6. Antti Petajisto. 2013. “Active Share and Mutual Fund Performance.” Financial Analysts Journal 69 (4), 73 – 93.
7. Brad Barber and Terrence Odean. 2000. “Too Many Cooks Spoil the Profits: Investment Club Performance.” Financial Analysts Journal 56 (1), 17 – 25.