avoid getting lured in by false investment performance claims
I grew up with two grandfathers who loved to fish. From a very early age, I learned not only how to bait a hook but also how to craft a story around that hook.
You know the kind: Man, the fish I caught and released was *THAT* big.
Every bit as important as what actually occurred on the boat was the story that followed. As a first-hand participant in the investment community, I understand now that the investment community has its own form of fish-y story.
Joshua Brown’s got quite an interesting post today on his blog, The Reformed Broker. The Interview with Johnny Upside is a parody of hedge-fund types, claiming to always be ahead of the game, positioned perfectly to make a mint. When backed into a corner, it’s clear that investors are only getting part of the story.
Well, you’ll say, what about their marketing materials? They say that they’re up X%. While not outright lying, funds conduct performance smoothing, taking returns and sprucing them up by comparing them to favorable benchmarks or specific to particular entrance dates into the fund.
While not outright lying, funds do good marketing by trying to make their performance look as good as possible. As Bernie Madoff has taught everyone, sometimes too good of a story turns out to smell like fish.
So, how does one avoid getting lured into investing with someone too-good to be true? I think answering this question requires framing the problem: how does an investor truly size up performance of a fund manager? Can you really believe performance quoted by managers?
Couple things:
- Investor communities create better visibility. Investment newsletters are great at giving selective performance numbers. They aren’t audited and they typically claim that they’ve made 3000% on a trade (without saying how all their trades have panned out — check out Stock Gumshoe to dig deeper on newsletter teasers). Companies like Covestor (read here for more coverage of Covestor) are comprised of communities of investors submitting their trading to real-time auditing for performance. Performance and metrics are completely above board and when looking at a manager, what you see is what you get. If all funds participated in investor communities, we could have avoided a Madoff-like scandal.
- Broker performance is by nature hard to quantify. Any advisor who creates personalized portfolios doesn’t have an all-encompassing performance metric to tell you how good his advice is. So, it’s difficult to really assess performance. Instead,
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- Ask how his best clients have done
- Ask how his worst clients have done
- Ask if new accounts are coming in
- Ask if people are pulling their money
Do some extra homework when looking at performance to ascertain whether performance is as good as it looks or just another tall tale.
