Sublime Sensex Scam

Stockmarkets have given rise to many types of scams over centuries. One of the classiest in terms of chutzpah was the 18th century public issue, which raised money "For carrying-on an undertaking of GREAT advantage but no-one is to know what it is!" 

One of the most enduring "420s" is the newsletter scam. It goes like this. A fraudster mails out a newsletter to let us say, 1?,?000 persons, claiming he has a surefire system for predicting the direction of the market index. Obviously he isn't giving away the secret sauce of how he does this.

But he can confidently assert that the Sensex will go up in the coming week. He doesn't want any money, initially. He just wants readers to track the prediction. The twist: he sends out a second newsletter, which states with equal confidence that the Sensex will go down this week. That bearish prediction goes to out to a different set of 1?,?000 people.

The chances of the Sensex staying unchanged for a week is low. One of those newsletters will prove correct. Next week, the fraudster focuses on the punters who received the right prediction. He splits that mailing list in half and sends out two opposed predictions again.

Two weeks later, he focuses on the 500 persons, who have received two correct predictions and sends out two opposed predictions. Three weeks later, he focuses on the 250 guys, who have now received three correct predictions. A month later, he makes a pitch for subscriptions from the 125 guys who have now received four correct predictions in a row.

?S?ome pay because of the solid track record! 

Note that if the fraudster keeps on sending out opposed predictions, and people punt on those predictions, some will actually make money. The larger the initial list, the longer the winning streak will be for some recipients.

Given an initial mailing list of 2,000, one lucky fellow will receive the right prediction for 11 weeks in a row. You will have a hard time convincing that man he's being defrauded since the newsletter has given him an "impossibly long" winning streak.

Versions of the newsletter scam have been pulled off many times. At first glance, this seems a little simplistic given electronic communications and social media. Traders share ?k?habar too obsessively for this scam not to be discovered eventually. But the scamster only has to pull it off for long enough to win a few subscribers.

Costs are negligible. In practice, a much larger database of email ids can be spammed, expanding the scale without increasing costs. Given an email list running into lakhs, some "lucky" fellows will pick up winning streaks for three months plus (assuming the scamster keeps the newsletter running). It is, in that sense, less obviously a scam than the highly profitable Nigerian absurdities.

There is a further interesting inference: it is very hard to distinguish chance from skill. A trader could toss a coin and through sheer luck, get long winning streaks. The chance of any given trader hitting a long streak this way is small. But if there are many traders, some will do it for sure.

Now consider the following: Lay investors are advised to invest via active mutual funds because the experts managing those are supposedly better at stock?-?picking. Ideally, their "expertise" helps them beat amateurs and also beat the market indices.

But are fund managers really better at stock picking than some method of random selection? In every developed market, the majority of fund managers under-perform indices. The Wall Street Journal ran a contest for years where WSJ staffers threw darts at a list of company names, while a group of fund managers picked stocks from the same list, using normal methods. The managers did not do better than the dartboard, as a group. Some beat the dartboard. Others did not.

Even if a given manager beats the market consistently, it is difficult to tell for sure if this is due to luck or skill. The return from any stock portfolio (or any financial asset for that matter) can be compared to the Sensex or Nifty, or any other stock index. However a given portfolio may be chosen, it will either beat the index, or it won't. (?T?he chance of exactly matching index return is low, if the portfolio does not mirror the index exactly. )

Any large, liquid stock-market has millions of active participants and hundreds of stocks. The numbers are large — too large to rule out luck when it comes to results. Some will beat the index two years in a row and some will beat the index five years in a row, by luck alone. Say, 10 per cent of active investors beat the index in a year. Next year, if the 10 per cent ratio holds, 1 per cent of active investors will beat the index two years in a row and the year after, 0.1 per cent will do a "three-peat". 

So the next time you are thinking of investing in a mutual fund, remember the disclaimer, "Past Performance is no guarantee of future results". There is actually reason to believe it!