Given some high-profile Ponzi schemes grabbing headlines in recent years, you might assume that investors have become more wary of investments that appear too good to be true.
Experiments conducted over the last two and a half years by Harvard Business school professor Max Bazerman and his peers, however, indicate otherwise.
The participants in the experiments—often business school students or members of the finance industry—were presented with performance charts for four funds and were asked to pick which one they would recommend to a client. Unbeknownst to the participants, one of the funds’ returns reflected the returns of a feeder fund to Bernie Madoff’s Ponzi scheme, one of the biggest and most infamous schemes in recent history. That particular fund boasted a track record of having the best, most stable and most unrealistic returns of the four choices.
Its “too good to be true” returns notwithstanding, the fund proved time and time again to be the most popular choice among participants in the experiments. But perhaps most surprising was that later, when participants were asked which of the four funds appeared suspicious, the Madoff-like fund also ranked no. 1.
Why the disconnect? Why didn’t participants notice that the Madoff-like fund could be suspicious before they decided to recommend it? The Alert Investor asked Bazerman to explain his research and what lessons retail investors should take from it.
Tell us about the first part of your experiment.
Max Bazerman: We ask people to pick between four possible mutual funds for a prospective client. It’s a simulation that puts people in the role of investment adviser. They see a chart with five graphs. One is the return of the S&P 500 over the prior nine years. And then there are four other funds.
One we call the Tobacco Fund—the Tobacco Fund outperforms that market, but the tobacco word is obviously a bit loaded for some people. There’s the Alpha Fund, which significantly outperformed the market. There’s the Power Trade Fund which dramatically outperformed the market but with very erratic returns, so it’s spikey.
And then there’s Fortitude, and Fortitude has consistently and dramatically outperformed the market with almost no volatility whatsoever.
What are the typical results?
MB: When we ask a classroom of people, whether it be MBA students or executives in the finance industry, they overwhelmingly pick Fortitude because the returns are fantastic and the volatility is low. Sixty to 80 percent is the typical percentage to pick Fortitude in this particular task.
So what happens next?
MB: We then ask the question, “Is there anything wrong with any of these funds? And a number of people will then quickly say, “Fortitude’s not possible.” It’s that you can’t dramatically outperform the market over an extended period of time with very little volatility in performance. The only way you can do that is with a very low risk investment, so you can’t outperform the market for such a consistent period of time, and that’s exactly what Fortitude has been doing. With Fortitude, all we did was capture the performance of one of the leading feeder funds that invested 100 percent of their money into Madoff.
What conclusion can you draw from your findings?
MB: Our observation is when you ask people, “What do you invest in?” ethics and viability sort of fade from the equation, and people are answering based on return and low volatility. The same people, when you ask them, “Is anything wrong?” can quickly notice the fact that Fortitude isn’t viable to begin with. So within that very small amount of time, people are able to shift based on the minor change in the question.
We think it mirrors what happened in the Madoff environment, where there were hundreds of smart people with MBAs, with PhDs in analytic fields, who had access to the data and simply didn’t notice that Madoff’s returns were never possible.
What lessons can individual investors draw from your research when it comes to managing their portfolios?
MB: Many people—myself included—basically believe that most individual investors should have no illusion that they can outperform the market and should probably be investing their money in index funds to begin with. But to the extent that the investor is not comfortable with that notion that they lack the ability to outperform the market, I think that they should be asking themselves, “If I think something is true, why haven’t other people noticed it. If I’m buying a stock, why is someone selling that stock? What do they know that I don’t know? What do I think I know that they don’t know?”
So we’re not only talking about noticing potential fraud—investors should also question why someone is recommending an investment to begin with?
MB: Sure. So if someone gives you a hot stock tip, do you take the time to determine whether the person giving you the tip stands to make money if you buy it? Do you ask if there is any reason to believe that the person giving you the stock pick knows more than the market in general? Too often we focus on a narrow slice of information and don’t think more carefully about what we can infer based on the situation that’s out there.
A report on the experiments conducted by Tim Zhang, Pinar O. Fletcher, Francesca Gino and Max H. Bazerman is available here.