Investors Raj Rajaratnam and Joel Greenblatt share a number of similarities. They’re almost exactly the same age. They both received business degrees from the University of Pennsylvania, and they both started well known hedge funds. But the differences may end there.
During the 10 years that Greenblatt operated his fund, Gotham Capital, it delivered returns averaging 50% per year. By way of comparison, the S&P 500 returned about 10% per year over that same timeframe. Owing to this success, Greenblatt retired from full-time work in 1994, at age 37. Since then, he’s written popular investment books, taught business school classes and devoted a large portion of his wealth to philanthropy. Among other initiatives, he’s given millions to cancer research and built the Success Academy group of charter schools in Harlem.
Rajaratnam’s story turned out differently. Back in 2008, during the depths of the financial crisis when banks were struggling, Rajaratnam received a tip that Warren Buffett was about to make a life-saving investment in Goldman Sachs. Acting on this tip, Rajaratnam’s fund bought Goldman shares and booked a $900,000 profit when Buffett’s investment was announced just a day later. When the government caught wind of this transaction, Rajaratnam was convicted on insider trading charges and sentenced to 11 years in prison.
When we think about financial malfeasance, names that typically come to mind are Ponzi and Madoff, but unfortunately, they’re not the only ones. Stories like Rajaratnam’s occur with regularity. The challenge for individual investors, though, is that it’s extremely difficult—without the benefit of hindsight—to tell the difference between a Joel Greenblatt and a Raj Rajaratnam. On paper, they would have looked virtually the same: smart, well-educated and possessing what appeared to be winning investment formulas. So how can you tell them apart? Below are five litmus tests you might employ.
- Red flags. Back in the 1920s, when Charles Ponzi began soliciting investors, he promised a 50% return within 45 days or 100% within 90 days. Today, if someone came along promising these kinds of returns, you’d immediately recognize it as a scam. But unfortunately, fraudsters have learned to make their pitches sound more credible. That’s a key reason, in fact, why Bernard Madoff was able to get away with his scheme for so long. Instead of making outlandish promises like Ponzi, the returns Madoff advertised were in the neighborhood of 10% each year—not too different from the market’s overall returns. That made his fraud harder to uncover—but still, there were red flags. Most notably, he refused to share the details of his investment strategy.
Sometimes the warning signs take a different form. Ponzi scheme operator R. Allen Stanford, who was convicted in 2012, grew up in Texas and earned a finance degree from Baylor. But when he established Stanford International Bank to peddle his phony certificates of deposit, he operated out of various locations in the Caribbean. That should have raised questions.
That brings us to the first lesson for investors: If a prospective investment is too difficult to understand, or if there’s anything else that strikes you as odd, you might want to move on. In some cases, the result will be that you’ll pass on an investment that might have worked out well. But you shouldn’t worry about that. As Warren Buffett often says, there are no “called strikes” in investing. There’s no penalty for being patient and waiting for another opportunity—because there will almost always be another opportunity.
- Personality. I recall once meeting an investment manager who bragged about how many miles he ran each day “with no music.” It was an odd boast, but it helped paint the picture of someone who would run through walls. Wall Street seems to have more than its fair share of storytellers like this, brimming with self-confidence and speaking in absolutes. But this sort of thing can distract investors from making clear-eyed assessments of risk. That’s why it’s so important to stay focused on the numbers. If a fund manager seems to be using emotional appeal as part of the pitch, be wary.
- Track record. Because this sort of self-confidence can be so convincing, I prefer investment offerings that aren’t personality-based and instead look for simple strategies with long track records. But this can still be an uphill battle. Why? Author Morgan Housel explains it this way: “The solution to 90% of financial problems is ‘save more money and be more patient.’” But people on Wall Street find that simple prescription boring, so they end up promoting investments that are more complex, including “derivatives, high-frequency trading, offshore tax shelters…” Wall Street’s powerful marketing machine then promotes these new investments. The lesson for investors: If an investment fits in the “new and interesting” category, it may be worthwhile—but there’s no rush. Allow it time to prove itself before committing.
- Information. On a related note, I almost always caution against private funds. It’s not that investors can’t do well, but the risk level is always going to be higher in a private fund, where there are fewer eyes on it.
- Faith. A final litmus test is to ask whether an investment requires an act of faith. Consider Enron. It started out as a conventional oil and gas business. But over time, it became something else. When it fell into bankruptcy, Enron was trading everything from water to paper to broadband services. And every time it expanded, its reputation seemed to grow, helping to inflate its stock price to more than 50 times earnings.
Investors hadn’t paused to think critically because it looked like Enron was inventing the future. But when one reporter looked through the financial statements, she found “strange transactions,” “erratic cash flows,” and an unexplained level of debt. This information was all public, and any other investor could have done the same research. They didn’t, I suspect, because they were distracted by the shiny vision of the future that Enron’s leaders had presented.
Peter Lynch, the legendary fund manager, offers this advice to investors: “Never invest in anything you can’t illustrate with a crayon.” It’s a simple but valuable lesson.