Money Talk is Polite Conversation

By G. Kevin Mathis, Investor Advocacy Intern, Spring 2019

The rattlesnake king, Clark Stanley, created the narrative of the snake oil salesman.  Stanley peddled his snake oil liniment to consumers at the 1893 Chicago World’s Fair. To gain credibility for his product he performed a show-stopping act for fairgoers. He snatched a rattlesnake out of a bag sliced the snake open and squeezed out what he claimed to be healing snake oil extracts. The fairgoers bit and bought Stanley’s snake oil liniment. Thankfully, the Food and Drug Administration (FDA), then known as the Division of Chemistry, also purchased some of the liniment. The FDA tested the liniment and found out that it was not snake oil, but a mixture of dangerous chemicals that could potentially injure consumers.

Beyond being the story that created the tale of the snake oil salesperson, Stanley’s story is the story of someone defrauding buyers.  These stories have several common elements that consumers can use to protect themselves. The aspect most prominent in Stanley’s snake oil scheme is that fraudsters tend to create a product that emulates a real product so that their claims about their product has some basis in truth. Real snake oil made from the oil of the Chinese water snake, which is rich in the omega-3 acids that help reduce inflammation, was quite useful. Stanley’s snake oil was a fake version of Chinese water snake oil that he claimed was real. He also inflated the benefits of his product compared to the real one. Understanding and identifying these commonalities can help protect consumers when the next rattlesnake king comes rolling into town.

How does knowing what Stanley’s story help investors? Investors are consumers that buy securities. Knowing stories of products with incredible claims can help investors build some healthy skepticism when it comes to the claims of financial professionals. That skepticism can cause investors to pause and question a financial professional. When their claims about a product exceed what is typical of that product or do not line up with the product that they claim it is investors should alert others. When investors communicate about bad investment products investment advisors hoping to defraud unwitting investors have little or no unsuspecting investors available to defraud.

I am discussing some other schemes and their essential elements so that consumers can build up some knowledge of what to look for when it comes to spotting bad investments. As investors learn these elements, they should remember that communicating with other investors is the most important thing investors can do to protect themselves. When it comes to bad investments is to talk about their investment experience the good, the bad, and the ugly.

Don’t be Squeezed by the Bubble

Asset price bubbles (Financial Bubbles) are pronounced increases in asset prices that depart from fundamental financial values. People were buying tulips based on the speculation that tulips would continue to increase created the Tulip Bubble. Some purport that 17th-century tulip mania was one of the earliest financial bubbles. The Beanie Babies craze of the 90s involved people buying stuffed animals in hopes of flipping them for greater profits. Some even devolved to the point of perpetrating criminal acts to buy and sell the toys.

Financial bubbles have existed throughout history, so how can investors protect themselves against the next one. Stanford GSB’s Peter Koudijs says a bubble is “where investors buy an asset, not for its fundamental value, but because they plan to resell, at a higher price, to the next investor.” Perhaps understanding some of what causes financial bubbles will help protect investors.

What do bubbles have in familiar, many people riding a wave of speculation.  Investors should talk about or ask questions regarding their investments true financial value and purpose. Conversations about the value of an asset can help investors determine the investment’s real worth when investors decide that an investment has little, or no value related to its purpose they may decide that purchasing it is an unnecessary risk. A product without asset prices grounded in fundamental values will not continue to appreciate. Breaking the feedback loop about the assets price is the key to investors preventing harm to themselves. Investors can speak with one another and break that feedback loop.

Trust the King?

The Polka King, Jan Lewandowski (Lewan), was convicted of defrauding investors. Lewan was so convincing that many people believed in the efficacy of his investment product; he even gained the audience of the pope. Lewan was known for his personality and performances. His charisma allowed him to sway investors. He used to skills to fund his venture. Lewan’s ventures included his travel tour business; a gift shop and mail-order catalog; and his media shows.

He sold promissory notes to his fans, and he used the money from his new investors to pay dividends to old investors. Many of his investors were elderly individuals, to whom he promised incredible returns. It was a classic Ponzi scheme.

Fraudsters tend to perform for investors or tell them what they want to hear. Perhaps fraudsters do this to hide their motives and the absurd nature of their claims. Alternatively, it may be a method of some charismatic salespersons. The way to break the spell of charisma and promises is to seek a second opinion. Talk to other investors not involved with the investments of the financial professional. Consult with another financial professional. Remember communication can lead to more information and help an investor make safer investment choices.

Beware of Secrets and Silence

“The World’s Largest Hedge Fund is a Fraud” that was the title of the complaint Harry Markopolos, a derivatives expert, submitted to the Securities and Exchange Commission (SEC) on November 7, 2005. The Bernie Madoff is the story of a seasoned financial professional creating a Ponzi scheme defrauding investors. How did Bernie Madoff and Madoff Investment Securities, LLC manage to fool so many investors?

Erin Averlund’s Barron’s article title says it all “Don’t Ask, Don’t Tell: Bernie Madoff is so secretive, he even asks his investors to keep mum.” The article discusses how Madoff was able to convince his investors to trust him without question. It seems that people trusted Madoff because he was the expert so who else could they trust. As Markopolos said in his complaint, very few people in the world even had the mathematical expertise needed to understand and manage the investment products that Madoff Investment Securities, LLC managed. Even though no one, including some of the few skeptical experts, could account for—or maybe even believed they could comprehend—how the world’s largest hedge fund consistently generated yearly returns of about 15% without experiencing any down years, people continued to trust Madoff’s reputation and expertise. The SEC’s Case No. OIG-509 Report of Investigation details how although some financial experts questioned whether Madoff’s hedge fund could yield such impressive results, people continued to trust Madoff.

Skeptics existed but people trusted Madoff because he was an expert with a long history in the market. Madoff betrayed the trust investors—including other financial professionals, doctors, lawyers, pension funds, and non-profits— placed in him. His expertise and track record seemed to indicate that he knew how to get returns on investments. Even the skeptics could not explain how his fund could yield implausible results without saying that the results were implausible. Investing with Madoff meant trusting the expert and relying on their knowledge. Madoff’s reputation seemed reliable in both respects.

Madoff’s Ponzi scheme teaches us that we can ask our financial professionals to explain their investments even if we trust them. Assisting others in understanding an unfamiliar field is an expert’s purpose, so they should not be offended if someone questions them. Most people are not investment experts, and some products are so complicated that even financial professionals do not understand them. A financial expert should be willing and able to help their investors understand the investment vehicles they are invested in so that uncomfortable investors, can decide not to invest. When a financial expert is unwilling to do this that should signal the alarm and investors should alert others that something may not be quite right. Even if a financial expert explains the investment to the point of understanding, seek the advice of others. Communicate with believers and skeptics to form a fuller picture of the investment. Also, if an investor does not feel sure about a product because they do not understand it, we can decide not to invest in it. Questioning an expert does not indicate a lack of trust; it is quite the opposite. People seek the advice of those that they trust.

Beware the Hype

Schemes to separate investors from their money have not ceased, they evolved. We may not be in the world of snake oil peddlers traveling from town to town to push some fraudulent product, but the concept is the same. Swindlers still use grand performances, unrealistic claims, speculation, reputations, proven expertise, and charisma to convenience individuals to buy what they are selling. Social media makes this process digital. Social media allows defrauded investors to speak out about fraudsters.

The promo video to Fyre Festival promised: “the best in food, art, music and adventure / once owned by Pablo Escobar / on the boundaries of the impossible / Fyre is an experience and festival / A quest / to push beyond those boundaries.” According to court documents, Fyre Festival founder William Z. (Billy) McFarland failed to deliver on those promises. The complaint against Billy alleged that he and Fyre Media: (1) made false statements concerning key Fyre Media and Fyre Festival financial metrics and assets; (2) falsified financial data; (3) made false claims of affiliations with talent; (4) created a fraudulent brokerage statement in order to suggest to investors and banks that McFarland personally possessed collateral sufficient to securitize investments; (5) made false statements and created a fake document concerning purported bank loans and a purported significant pending investment in Fyre Media; (6) claimed, falsely, that he would obtain event cancellation insurance for Fyre Festival; and (7) engaged in a scheme to create the illusion that Magnises was being acquired by a third party that did not exist. The SEC said that Billy agreed to settle charges—at least $27.4 million from over 100investors—arising from the Fyre Festival debacle.

Fyre Festival exemplifies social media being used to defraud consumers and to expose the fraudster. Fyre Media utilized social media influencers and social media marketing to promote and advertise his product. This type of marketing style is popular because people consume a lot of online media. Moreover, social media platforms allow advertisers to reach a broader more diverse audience than some conventional means of advertising. Someone intent on deceiving large swaths of possibly unconnected individuals can use social media to their advantage to dupe individuals. Fyre Festival “attendees” and the Bahamas Ministry of Tourism used social media to communicate to the world cultural moment was an extreme disappointment. Social media sparked the flame of Fyre Festival and burned the façade to the ground.

Investors can use social media in the same way that those duped by the Fyre Festival. Investors can use social media to communicate with one another about times when investments caused them harm. Investors can even expose investments that fail to meet their promised returns. Talking about their investments can allow investors to start a conversation that could save others from suffering the same losses that they incurred.