Saturday, April 2, 2011

How To Smell A Rat: Chapter 3

Recessions seem to unearth a great number of financial frauds. But by then it is usually too late, as investors end up losing most if not all of their money. In this book, value investor Ken Fisher (son of Philip Fisher, whom Warren Buffett cites as someone from whom he learned a great deal about investing) describes five ways ordinary investors can protect themselves from being duped by a fraudulent money manager.

Fraudsters aren't really generating the returns they say they are, and therefore they can't come clean about their investment strategy. As a result, they use a lot of jargon in their strategy descriptions in an attempt to make the investor feel too stupid to ask questions. Investors must ignore the tendency to shy away from asking question, and only invest if they understand the strategy, and can compare the manager's historical returns to a benchmark that mimics the strategy.

A legitimate manager won't mind a potential client trying to get a better understanding of the investment strategy. That manager wants the investor's business, and is therefore willing to have someone explain the strategy very clearly, even to someone without a financial background.

But a fraudster doesn't have a strategy that he is willing to admit to publicly, so he will make the strategy sound complicated using a lot of mumbo-jumbo, or seem angry/insulted when asked for more details. For this reason, Fisher recommends that investors ask for a simpler interpretation of the investment strategy until it is clear enough for them to understand. If the manager can't do this, it's time to walk away.

Fisher describes the story of one potential investor in Madoff's fund who just couldn't get a coherent explanation of what Madoff's investment strategy entailed. Madoff couldn't, or wouldn't, and so the investor walked. Obviously, it saved him a lot of money. Fisher also gives other examples where fraudsters were vague about their strategy descriptions, for if they weren't, the public would be able to see that the historical returns being presented just weren't possible.

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