Modern Investing

by David Schneider

  Spitznagel is different. He is willing to lose a bit every month and for a couple of years in a row if necessary. He makes a killing in one swoop, usually resulting from one disastrous moment for financial markets. Spitznagel did this in 2008 and 2009, with a recorded performance of about 100% for his hedge fund, which doubled his billion dollar hedge fund in size. The 2010 Flash Crash was blamed on him, because he had a large bet on falling prices before the flash crash, which led him to profit disproportionately from this market anomaly. We now know that he had nothing to do with it. He simply had his regular trading positions in place. In 2015, he made another $1 billion for his investors, when markets suddenly worried about the financial conditions in China.

  He calls his form of investing: “round about” investing. Though riddled with mathematical complexity, this strategy in its core is very simple. Since he only places bets on mispriced financial products, Spitznagel found a perfect niche for himself that won’t be overcrowded anytime soon. Not a lot of investors are willing to lose a bit month after month only to wait for the big payout. They would rather win a bit month after month and lose a lot in one clean swoop.

  All these strategies have one unifying aspect in common; the money game provides their lifeblood. They profit from the tiny or significant market inefficiencies this game provides, caused by an imperfect system and played by imperfect players. They thrive and feed on the masses of uninformed, slow and less sophisticated players. Without them, Wall Street wouldn't be what it is today. But it doesn’t stop there. Where so much money is involved, characters that are less patient and less inclined to play by the rules are attracted. Rather than be exposed to any residual risk, all gamblers have to deal with whatever their skill level; a small group of professional players have always been on a quest to eliminate all risks, and they know how.

  CHAPTER 8

  THE BIG CHEATS

  “I'm scammed almost every day.”

  – James Altucher

  As we have seen, smart investors seek an edge over others through superior and sophisticated work, better technology, a better strategy, and better information. We have seen that they make use of the same mathematical principles that professional gamblers use. As in real casinos among gamblers, there are always less morally declined players, who are not satisfied with a mere mathematical edge. It just isn’t enough. Too big is the chance that money could still be lost if the vagaries of uncertainty strike at any time and will. They want the ultimate edge.

  There is no better place to cheat, commit fraud, hide it under cover of sheer complexity, and receive higher incentives than in the financial markets. The most astounding reality is that most of the time, the guilty ones get away with it. For even the least informed citizen, it should be clear that financial markets are obviously places where stronger, more informed players exploit weaker players to gain an unfair advantage. As Tom Hartman claimed in The Coming Crash, “The industry as a whole is exploitative and corrupt.” Matt Damon noted in his commencement speech at MIT 2016 that the subprime crisis “...was theft,” and furthermore that “[Wall Street] knew it. It was fraud, and you knew it. And you know what else? We know that you knew it!" He would know; he was the narrator of the 2010 award-winning documentary “Inside Job” which portrayed the subprime crisis in all its dark facets.

  However, what’s most telling about Matt Damon’s speech is how little traction it got from his audience. And this isn’t surprising, because it’s in the nature of the system to appropriate the very people it victimizes. For thousands of MIT graduates heading off to Wall Street to pay off their colossal student debts, the temptation to cut corners is powerful. Now imagine if you join an institution where fraud, corruption, and secrecy are a part of the culture – like Enron or BCCI. If you had the chance to make $2 million in one day, and if your bosses and colleagues all agreed that they’d cover your tracks if you broke the law– wouldn’t you be tempted? For people at the top, the rewards of fraud and skulduggery can be far greater than just paying off debts.

  There’s no more notorious example of the temptations of financial fraud and its astronomical rewards than Bernard Lawrence "Bernie" Madoff. He was convicted of a staggering $17.2 billion dollars of fraud in 2009 and was sentenced to 150 years in jail. Once a big hot shot on Wall Street, Madoff even became the non-executive chairman of the NASDAQ stock exchange and owned his charity. He could have stayed there if he hadn’t been a direct victim of the aftershocks of the subprime crisis in 2007.

  In a recent jailhouse interview, he described decades of steering clear from scrutiny by regulators and “gullible customers,” a phrase that he uses to refer to his former clients. According to Madoff, “Retail investors are the least well-informed market participants. The individual investor is the last person that has any information.” He came to a very simple conclusion: “Scamming investors has been going on since the beginning of time, and I don’t think it’s going to end.”38

  This begs the questions: what popular scams are out there, and how do more informed and stronger players prey on the weak and less knowledgeable? How do you avoid being prey? It is clear that any student of investing needs to deal with these topics or they will suffer the financial consequences. In the two following chapters, I will provide an overview of some very disturbing facts and practices that any individual investor must be aware of before setting sail.

  Confidence Tricks

  It has been said, “Confidence tricks exploit typical human characteristics such as greed, dishonesty, vanity, opportunism, lust, compassion, credulity, irresponsibility, desperation, and naïvety.” Many con artists target the elderly, misinformed, and uneducated, but even professionals and academics fall victim to confidence tricks. In financial markets, there is never a lack of “gullible” targets.

  One type of con is the so-called long con (also known as the “long game”). A scam that unfolds over an extended period and involves a team of swindlers, as well as props, sets, costumes, and prepared lines. The purpose is simple: “To rob the victim of huge sums of money.”39

  In investing, con tricks contain most of the steps of traditional cons. There is the “Foundation Work:” the preparation in advance, including the hiring of henchmen required. Then there is “The Approach:” the victim is contacted through social media, investment boards or traditional routes (TV and door-to-door salespeople). Next is “The Build Up:” the victim is presented with a profit scheme that appeals to the victim's greed. There is even a “Pay-off or Convincer, ” in which the victim takes a small payout as proof that the scheme works and that the con artist can be trusted. In a gambling con, the victim is allowed to win several small bets. In stock market cons, the victim is lured in through easy gains in the stock market, such as sure tips or IPO shares.

  Finally comes “the Hurrah:” a sudden crisis or change of events forces the victim to act abruptly and usually under duress. It’s a catalyst for transferring money quickly from one pocket to another pocket. In past financial markets, the Hurrah catalysts have always been market crashes, panics, sudden loss of confidence in a scheme, and most recently, flash crashes, “a very rapid, deep, and volatile fall in security prices occurring within an extremely short time period.” Let’s take a look at one of the most famous financial scams– the “Ponzi scheme.”

  Ponzi Schemes

  The most common form of a financial market long con is the classic Ponzi Scheme. Named after Charles Ponzi, an Italian businessman and con artist. Ponzi schemes can be breathtaking in their scale, due to the fact that their success and failure hinge entirely on the imaginations of everyone involved.

  Born in 1882 in Parma, Italy, Charles Ponzi arrived in Boston in November 1903. Financially destitute upon arrival in the U.S, he had no choice but to chase the American Dream. Early on he did several odd jobs, including dishwashing, until he got involved in a few financial scams that got him thrown behind bars twice.

  Resourceful and go-getting, he finally found a legitimate investment oppor
tunity that had elements of a simple arbitrage scheme. But, he was impatient and realized that using his own funds couldn’t increase his wealth quickly enough. Always the creator of getting rich quick schemes, he needed financial leverage. The leverage would come from raising money from outside investors. To attract new investors quickly and to create his own “going viral” campaign (20th-century style), “he promised investors outrageous returns of 50 percent in 45 days, or 100 percent in 90 days.”40

  To show proof of his promises, Ponzi paid early investors returns using money from new investors, rather than with actual profits. The trick worked and soon investors stormed his office to hand over their cash. However, it went downhill from there, and most investors would never see a dime again. It might have worked out for Ponzi, had he used the remaining funds to invest in his profitable arbitrage operation and reduced return expectations. Instead, he spent the raised money lavishly, as if it were his own. According to a newspaper article: “He bought a mansion in Lexington, Massachusetts, with air conditioning and a heated swimming pool.”40

  His house of cards collapsed in August 1920, when The Boston Post investigated his miraculous gains. It set off a run on Ponzi's company, with investors losing confidence, as quickly as they had been captivated with promises of easy money. It was too late; the money was gone.

  Though the original Ponzi scheme was based on fraud, nowadays they usually start with legitimate business operations. Initially, everything appears kosher, and the first profits are genuine. What follows is a typical scheme on Wall Street. An operator will artificially bump the price of a hot stock, internet startup company, or penny stock. This lures in new customers whose investments function as payoffs for people who invested earlier. Of course, con artists fill their own pockets, too. The system is self-sustaining; new investors provide money for those few investors leaving the party, but spread the good word. This is crucial—little to no value is actually being generated. The stock prices are usually horrendously overpriced and produce no real profit. The people who run the scheme gather money from one wave of investors after another, taking most of it, and passing it off enough to another set of older investors to keep them happy. The people who put in money first, usually get out soon enough to reap all their profits. Eventually, of course, the money runs out and the whole thing implodes. The most “gullible investors” in the final waves of the buying frenzy are usually the last and have the largest losses. In a way, all financial bubbles are elaborate and lengthy Ponzi schemes. If we take a closer look at the mechanics of the dotcom bubble, we would all agree with this observation.

  Lasting from roughly 1997-2001, this was a period marked by the founding of several new Internet-based companies (commonly referred to as dot-coms). On one hand, the whole world was frightened by the potential of the “Y2K” bug to wreck their services, banks, and industries which had invested heavily in their IT resources. On the other hand, people believed that the Internet was the future and that nearly every single company that claimed to be a “dot-com” immediately became popular, even if it had little chance of success.

  The early businesspeople who did succeed, e.g. Netscape founder James Clarke and Broadcast.com CEO Mark Cuban, made billions. These were the early adopters and winners who became the role models everyone sought to emulate. The stock prices for many businesses rose so rapidly that a global buying frenzy for all things related to the internet and technology broke out. It climaxed around March 2000, then the bubble popped. Many dotcoms disappeared as quickly as they had gotten famous. A panic broke out, and the stock market crashed; millions lost their investments, and a few even committed suicide. Those who sold early and cashed in their chips, due to foresight or sheer luck, kept their millions and billions.

  One symbolic figure that stood out amongst all the successes and failures of the bubble was Frank Quattrone. He was the new poster child for greed. Quattrone helped companies such as Netscape, Cisco, and Amazon go public. At the peak of the bubble, he was earning roughly $120 million a year. In the aftermath of the dotcom bubble in 2003, he was prosecuted for interfering with a government investigation into the bank he used to work for, Credit Suisse First Boston (CSFB). CSFB came under scrutiny by federal authorities for its behavior in allocating popular IPOs to a few favored clients in exchange for inflated commissions for other banking services.

  Apparently, Quattrone and his “West Coast gang” had created lucrative investment accounts loaded with the hottest and most sought after IPO stocks– stuff that would cause intense mouth-watering and fainting for any IPO hunter today. These stuffed accounts were for banking clients who became known as “Friends of Frank.” The friendships didn’t end there. Once the “Friends of Frank” allocated these sure bets, they were required to pay back Quattrone with banking business– lucrative deals for Quattrone’s firm. Failing to return the favor meant they were no longer Friends of Frank, and they would never see a single hot IPO share again anywhere in the U.S.

  Notified of the impending investigation, he instructed his office to erase relevant documents and emails. Rather surprisingly, he never had to go to jail and all his legal fees–though substantial– were paid by CSFB in full. After the trial in 2006, he quickly claimed his overdue compensation (in the range of $100 to $500 million) that CSFB still owed him, on top of hundreds of millions more that he had stashed away. There were rumors that he was considering opening up a major charity and going into philanthropy to help orphans and widows.

  Insider trading

  Another form of skulduggery that every investor is aware of is insider trading, the movement of information that could have an impact on a stock’s value before the information has become public knowledge.

  Imagine CEO Fatcat, in whose corporation Fat Cat Inc., you own $400,000 worth of shares. He calls you in the middle of the night, because he’s been caught embezzling. He’s your friend, so he gives you a heads up: sell now, because in the morning, Fat Cat Inc. is going to be worth nothing. So, you sell by dawn, then sit back and watch everyone else go broke. Congratulations, you’ve just completed your first insider trade, and you’ve broken the law.

  Martha Stewart comes to mind as the most prominent individual investor who got caught in the most blatant form of insider trading. In December 2001, her broker tipped her off that ImClone, a biopharmaceutical company that she had invested in, was declining in worth. It’s new drug, Erbitux, had failed to get the expected Food and Drug Administration (FDA) approval. Top management and directors were informed in confidence by the authorities. Apparently, Martha’s broker got wind of it as well. Stewart ordered her broker to sell ImClone as soon as possible. When the rest of the market was informed, ImClone’s shares price dropped like a stone. Martha’s timing was opportune, but also extremely suspicious. Was it willful insider trading, a mental blackout, or her own suffering from cognitive biases? We will never know. Naturally, she denied all charges. According to court records, she was able to save $45,673 from insider trading. Considering her net worth of $85 million that year, it was a minuscule amount. In July 2004, Martha Stewart was sentenced to five months in prison, five months of home confinement, and two years of probation for lying about a stock sale, conspiracy, and obstruction of justice.41 Apparently, the prison sentence didn't hurt her financially. In 2015, her net worth was estimated to be north of $300 million.

  Converting inside information to capital growth has always been a part of stock exchanges. The very first cases of insider trading can be traced back to the first bubbles and financial crises. In the age of Adam Smith, stockbrokers and aristocrats frequented the gentlemen’s clubs. They freely traded tips and rumors and made timely purchases and sales to make more money quickly. At that time, not many people were shocked about this. It was the nature of how information traveled before modern communication.

  That changed in the aftermath of the Stock Market Crash of 1929. A few people on Wall Street were able to liquidate their position early on, hence securing their wealth. But, thei
r insider sales further depressed prices. It was an outrage for all other players, in particular for those, far from Wall Street, who learned of the crash several hours too late. As a result, Congress enacted the first insider trading laws and established the Securities and Exchange Commission (SEC) to enforce it. But obviously, it wasn’t enough to control or even contain insider trading, as the following case of Raj Rajaratnam shows.

  Raj Rajaratnam, founder and owner of the Galleon Hedge Fund Group, was arrested by the FBI and was found guilty of fourteen counts of conspiracy and securities fraud in October 2011. He was sentenced to 11 years in jail, which was one of the longest sentences ever given for insider dealing. Rajaratnam had developed a broad network of tipsters and business contacts who provided a steady flow of insider information. Once he was in possession of such vital information, he created an alibi for his subsequent trading actions in the form of selected research that he quickly fabricated or borrowed from numerous brokers. The case of Nortel Networks is symbolic of all of his insider trading activities. On one trading afternoon, after hanging up the phone, Rajaratnam stormed out of his glass office and called an emergency meeting with his top lieutenants. What followed was a scene right out of the movie Wall Street.

  First, Rajaratnam ordered his analysts to write a research note on Nortel. In this note, they were to argue that Nortel’s management hadn’t shown up at a scheduled investor’s conference, causing frustration and doubts among traders and investors, which would impact the entire tech sector. He, then, ordered them to send out emails to interested parties. It was the perfect justification to liquidate Galleon’s heavily concentrated tech stock portfolio, and to “short” tech stocks. While his analysts were feverishly drafting these research notes, he ordered his traders to liquidate their Nortel positions and most of their portfolios.