In a previous blog we discussed some simple ways to avoid being taken in by a Ponzi scheme such as the one run by Bernie Madoff. But good scammers are very convincing. In an effort to encourage everyone to be skeptical of investment claims, we’d like to share with you a stockbroker scam that made the rounds not too long ago.
You receive a phone call (this was before the Do-Not-Call Registry went into effect) from a broker you do not know. We’ll call him Sam. He tells you he would like to be your broker but, since you don’t know him, wants to prove to you why you should give him your business. He then gives you a prediction: the price of McDonalds Corporation stock, currently selling for $27 a share, will go up over the next month. For now, that’s all. He says he’ll call you again in one month to discuss the results.
It’s now one month later. You receive another call from Sam, who asks you if you’ve been following McDonalds stock. You haven’t. He asks you to check the newspaper. Sure enough, McDonalds is now selling for $29. But, of course, that could just be luck. “So let me give you another prediction,” Sam offers. “How about IBM? It’s currently selling at $83, and it will rise over the next month.” “By how much?” you ask, somewhat jokingly. “I don’t know,” Sam replies, honestly. “I can’t predict the amount, just the direction.”
This time you do follow the price of IBM stock over the next month. After an initial drop, it does indeed turn around. By the end of the month the price has risen to $86.50, and you receive another call from Sam. “What do you think about my prediction?” he asks. You’re impressed. But not yet convinced. “I can do it again,” he says. “Check out Alcoa Aluminum. Its price is going to go down over the next month.”
Sure enough, when Sam contacts you a month later, Alcoa’s share price has dropped. You ask him how he is able to predict price movements so well. “It’s a combination of technical and fundamental analysis, together with some proprietary analytical software my company uses,” he tells you. This time he asks if you are ready to invest your money with him. At this point you are convinced, and you answer yes.
How did he do it? Was it luck? Good guesswork? Did he really have a system?
Actually, it was none of the above. Sam simply started with a list of 160 contact names that he purchased from somewhere. He called all of them, telling 80 of them that McDonalds stock would go up, and the other 80 that McDonalds stock would go down. After waiting a month, he checked the price of McDonalds. Since it went up, he eliminated from his list the 80 people to whom he told it would go down. He then called the other 80 people, telling 40 of them that IBM would go up, and the other 40 that it would go down. And so on. After three months there were 20 people to whom Sam had made three correct predictions in a row. As you can see, there’s not much analytical skill involved.
How can you avoid being taken in by such a scam? By following two simple rules: (1) never believe anyone who claims to be able to predict the future, and (2) avoid investment advisors that claim to be able to make you more money than anyone else.