Perspective 1: Take full responsibility of your investment action
I used to have only one perspective on the responsibility in financial losses. That perspective is that everyone, including me, must assume 100% responsibility when we make losses from buying or selling any investment products. When I buy a stock, whether it’s on the recommendation of a broker or friend or family member or investment gurus or news articles or my own analysis, I must be fully responsible for the negative outcome. That means I cannot and will not blame anyone for my own losses even if the counterparty or third party deliberately cheats me for their own benefit, such as financial data manipulation by the company, over-promise of business prospect by the management, misleading information from financial consultant, irrational assumptions by financial analysts, wrong tips from anyone, ponzi scheme or outright investment scam, etc.
With this perspective of taking full responsibility, we are forced to think independently, assess the risk and reward of each investment case, make our own decision and accept any potential losses. If I make losses from stock investment on the recommendation or analysis of someone, it’s my own mistakes. If I trust someone to invest for me but make huge losses, then I have to blame myself for trusting him/her.
Bill Ackman, the billionaire hedge fund manager, wrote this in his annual letter to shareholders after $4 billion loss in Valeant Pharmaceuticals: “My approach to mistakes is that I personally assume 100% of the responsibility on behalf of the firm while sharing the credit for our successes”. That’s certainly a very good attitude to have, and I encourage every investor to share this same approach to mistakes.
Perspective 2: Financial market itself is responsible to actively spot and eliminate fraud.
But after being in the financial market for several years and seeing how unethical some people behave, I develop another perspective. This new perspective is not one that I will apply to my own case. Basically, it’s an observer’s perspective, a perspective I apply when I look at the financial losses of other people, especially when it’s deliberately caused by irresponsible people or scammers. If we see someone losing lots of money to scammers and tell them to take full responsibility for their losses, we are really just rubbing salt to their wound. If we are not helping, at least don’t say anything to hurt them even more. The worst thing they want to hear after the losses is “See, I told you so”.
This new perspective is that the financial market itself is responsible to actively spot, avoid and eliminate (potential) fraud. Monitoring by the regulatory authority only is clearly not sufficient. The regulators simply don’t have enough resources to oversee every single investment transaction. It’s impossible. The financial market in aggregate is formed by all the participants (buy-side, sell-side, banks, regulators, you and me and everyone else). If every market participant, especially the experienced ones, contribute by raising red flag when they detect a fraud or potential fraud, this will avoid billions of dollars of losses to fraudulent activity over time. When fewer fraudulent activities take place, public confidence in the financial market will rise, and also more money will be available for real investment in financial market.
Economists often see financial market as self-regulated. This works only to a certain extent. There are many irresponsible and dishonest people in the market who will intentionally lie and cheat for their own benefits. Many of them never get caught and penalized for their fraud. In the end, the cheaters live great lives with all the money, while the victims, usually the ignorant ones, live poor. This happens all the time. Usually only those that get exposed are reported in public news.
I started developing this perspective during GRC in 2008-2009 when I heard that some old folks lost their savings in investment products sold by banks. The old folks might have bought the investment products, such as corporate bonds, assuming that these were safe. When things went wrong, the bankers said the buyers were fully aware of the risks at the time of purchase, and the buyers said the bankers misrepresented the risks, and buyers bought because they thought the products were no-risk or low-risk.
We can’t side with either party completely. Some old folks are financially-literate and high-risk takers. In fact, some of them are day-time traders, buying and selling securities all the time. However, some old folks are financially-illiterate and focus on the safety of their savings, not on getting extra return. 100k may be all they have in their bank account for a life time of savings. It’s the latter that I think the financial market has the responsibility to protect.
How? I don’t know. That’s the problem.
Should we teach them financial knowledge so that they know what to invest and what not to invest? If we do, that’s good and over time, we’ll gain their trust. Now, if they trust us, what’s next? What if we exploit the trust now? What if we ask them to buy/invest in something expensive so that we get good commission? What if we sell them something overpriced? They will easily fall prey because the trust is already built. Then we go back to the same problem.
Basically, we don’t have a solution that works for everyone. High-risk-takers take their high risk and aim for the high rewards. Scammers who want to target them can exploit their greed. Low-risk-takers fear of losing money. Scammers can target them by first building the trust, and then exploiting the fear. Scammers aim to turn their ‘fear of losing money’ to ‘fear of missing out’ good opportunities.
Some of the fraud that I have seen personally (either I or the people I know engaged with these cheaters directly): stock price manipulation, accounting manipulation by company, lie on the business prospect by management, recommendation to buy risky stocks for high commission, promise of 10-30% monthly return on stock investment or peer-to-peer lending or gold investment, which turned out to be ponzi scheme, promise of 100% monthly return on stock trading (the young guy even said he’ll be a billionaire in 2 years), stock tips to buy overpriced stocks that eventually lost more than 80% the value. Some of my friends paid huge fees for the painful lessons. One was scammed for several million dollars, including his parents’ savings!
That friend who lost millions was a high risk taker. He fell to greed. The property agent promised 20-30% return for short period on property investment and showed her track records and testimonials from others. Then he got his parents to invest their savings too. I’m not sure if the parents trust the property agent, but I know they trust their son. They got their promised returns for first few months, and the snowball kept rolling. Another relative of mine got attracted and invested 10k. She got her 30% return in 1-2 months and continued again for another 30%. After 60% wonderful return, she quit because she didn’t believe it could run long enough. As you can guess, it’s a ponzi scheme. When the agent could no longer give 20-30% return or give back the principle on redemption, she ran away with her husband.
The biggest ponzi scheme in the world has an estimated size of $64.8 billion (the actual money lost was probably one-third of this reported figure). It was run by Bernie Madoff, who made billions for himself. It took several decades for the ponzi scheme to finally get exposed. Until now, no one really know when the ponzi scheme started. Some analysts raised red flags about Madoff’s scam for several years in 1990s and 2000s, but it’s unthinkable how Madoff could get away for so long. This serves to tell you that scams can go undetected for as long as several decades!
Why scams go undetected
Given that so many participants are watching and working in the financial market on daily basis, how come there are still so many fraudulent activities that go undetected for a long time?
Sell-side analysts study many companies and their financial reports all the time. But, they are not incentivized to issue negative or critical reports towards the suspicious companies. First, negative reports may hurt the relationships between their own firms (usually banks) and the targeted companies. Even if there is no relationship at the moment, their own firms may want to establish business relationship in future. Second, the targeted companies may boycott the critical analysts from company meetings/conference calls or threaten to sue. This can hurt the career of the analysts. Third, the business of sell-side is to encourage the clients to trade more (buy and sell more stocks). Many large institutional investors are also restricted from short-selling. So, time will be better spent to encourage clients to buy stocks or sell when expensive, but not to short the suspicious ones.
Buy-side analysts/funds will issue negative reports for their own benefit. Short-sellers will have shorted the companies first before issuing the damaging reports to profit from falling prices. Some people hate short sellers, but they do play a role in the stock market. In some cases, they help uncover the frauds or prevent the share price from reaching even more ridiculously overpriced levels. However, not all companies can be shorted, many of which also have illiquid stocks. Fraudulent companies flying under the radar will continue flying undetected in this case until their size and volume become big enough to get attention. Also, many buy-side firms focus only on long, not short. When they detect suspicious companies, they’ll just bypass them and look for another one worth investing.
Regulators often sets policy and lets the market run by itself. They are like police. If you don’t report anything to them, they will not take any action. This is partly understandable because they have limited resources. There are hundreds to thousands of public listed companies in the stock exchange, and no one can really oversee what each one is doing.
Auditors follow audit procedures, and audit procedures are not designed to detect frauds. If you know the audit procedures well, you know what the auditors will ask and what they will not ask. Many expert fraudsters do such a good job of covering their misdeeds that the audit procedures have little chance to uncover it. If the transactions look just ambiguous, auditors might just bypass it. After all, no one want to offend the employer/customer and lose the business.
Basically, there is self-interest at play. Each market participant is doing something for his/her own benefit, but this also includes the scammers. The scammers receive the most benefits when they succeed, albeit at the high risk. That’s why they will go a long way to cheat the ignorant ones.
People who detect the fraud or potential fraud will inform their friends or family to avoid such fraud but not go all out to tell the general public of such fraud. Why? Because there is a chance that he could be wrong too, which will backfire. Others who don’t know him may not believe him either. It’s also not easy to gather the evidence to prove the fraud.
As you see, I don’t really have a good idea on how we can improve the financial system to minimize the losses of ignorant people to frauds. No matter what we do, there will always be fraudulent activities going on because the rewards are high. At the end of day, perhaps the best advice is still for everyone to assume full responsibility of their financial well-being, to take care of themselves.