“Hey... Would you say you are on the lookout for new investment opportunities?” he said.
Shit. Things had been going so well to this point. I was pitching some things I had been working on and he was claiming he had some business opportunities. I didn’t put a whole lot of faith in getting a consulting engagement out of it. I had seen it a few times where he seemed pretty gung ho and got people working and researching a project only to see it go nowhere.
I was there to do my pitch as a dress rehearsal. If something came of it, great. If not, I wanted to keep my time commitment to an absolute minimum. Now it looked like I wasn’t the only one pitching. This is the last thing that I wanted.
I gave a very non-committal and disinterested answer. He was not deterred.
“I’ve started a hedge fund,” he said. This is the same guy, who just three years earlier, was an expert in Service Oriented Architecture. As co-workers, in the office together, it took me about ten minutes to realize that he didn’t know anything about Service Oriented Architecture. He had never seen an Entity Relational Diagram or have any knowledge of basic data modelling.
He continued, “Even in these difficult economic conditions, we have been giving our investors returns of 5-8%,” he paused for dramatic effect and then smiled, “PER MONTH.”
I nearly spit my drink out. A return of 6% compounded monthly would mean doubling money EVERY YEAR. 100% annualized returns simply do not exist. This was crazy talk. Santa Claus, the Easter Bunny, and the Tooth Fairy are far more real than 5-8% returns compounded monthly.
And yet... he seemed very sincere. “I can let you in on the friends and family program for just $25,000,” he offered.
At least I had an easy out. I politely declined siting my lack of $25,000 in cash. He left the line of communication open and said to give him a call if I changed my mind. I did a few hours of research on some of the other business we discussed and found, quickly, that it was a terrible idea.
I told Julie about the conversation and the 5-8% returns part. “How do you know he can’t do it?”
“Because when something is too good to be true - it is. Period. He seemed sincere and that’s the part that scares me the most. There are a few explanations for it, but none of them are sustainable.”
“He mentioned tracking currency exchanges going back one hundred years. The thing is, currencies from a hundred years ago have absolute no relationship to currencies from today. It’s like comparing Michael Jordan’s Bulls teams from the 1990’s to Derrick Rose’s Bulls of today. Both teams play in Chicago, but that’s all they have in common. They have different players and different coaches. Any statistics from MJ’s teams are completely out of context when comparing them to Rose’s team.”
“There are a couple of possible explanations, starting with this is a straight up Ponzi scheme. Basically, early investors get in on the ground floor. New investors come in flooding the fund with money, they claim the money is coming from investments, but it’s really funded by new investors coming into the fund. Everything is great for everyone, until the source of new investors dries up. This is exactly what happened with Bernie Madoff. Early investors who were smart enough to get out, made great returns. The new investors paid for the old investors, but anyone who didn’t cash out lost everything when it all came crumbling down. The Ponzi scheme is outright fraud and illegal. It relies on the illusion of legitimacy while acquiring new money. I don’t think he thinks he is defrauding anyone. It’s possible that he’s just the face and the illegal activity is happening behind his back without his knowledge. In fact, I’m willing to give him the benefit of the doubt.”
“It’s also possible that he’s doing technical analysis or day trading on momentum. Similar to the Ponzi scheme, this would be relying on the ‘Greater Fool Theory’. Essentially, a commodity - a stock, a property, a precious metal; continues to rise in price because it has been rising in price. As more and more people are drawn to this momentum, the price goes higher and higher. The good times continue as long as someone else - the greater fool, is willing to keep buying the commodity. When there is no greater fool, whoever is left holding the commodity loses everything. This happened with tech stocks around 2000 and housing prices from 2005-2008. The biggest difference between a Ponzi Scheme and the Greater Fool Theory is that speculative bubbles via the Greater Fool Theory are not illegal and are not outright fraud. Although... I’m sure investors in Pets.com would beg to differ.”
“The last possible explanation I am willing to accept is that weird and fluky things happen. Given enough time, the improbable but not impossible will happen. I remember playing in the Venetian Deep Stack and we were right on the bubble. Everyone was looking to bust the short stacks so we could all be in the money - it’s kind of an implied collusion that’s a part of the game. Someone with a very short stack goes all in and gets a caller. Ordinarily, anyone who can afford it and has a reasonable hand should just call and not re-raise. It should then be checked down to the river to give the best odds of busting the short stack. However, a guy goes all in on top of the caller and the whole table is pissed. Just a moment later, the raiser shows pocket aces and busts the short stack. Now we’re down to just one player left to bust before we all make the money. We’re going hand for hand with the other tables, so it takes a while before the next hand is dealt, but sure enough, a short stack goes all in, gets a caller, and the SAME guy goes over the top. Again, the table groans and he then shows pocket aces AGAIN and we all shut up and watch him bust the bubble.”
“Now most of us left are celebrating being in the money, but I’m stumped. Rather than being happy that I just cashed in my first major tournament, I try to figure out the odds of being dealt pocket aces twice IN A ROW. The odds of being dealt pocket aces on any given hand is 1:220. Therefore, the odds of being dealt aces twice in a row is 220 times 220. I whip out my iPhone and see that the odds are 1:48,400. It’s highly improbable, but it’s not impossible. I wouldn’t have believed it if I hadn’t seen it with my own eyes, but I assure you it did happen.”
“Back to this guy. It’s possible that plain old dumb luck is allowing for eye popping returns. But it’s nowhere near sustainable. Luck is a fickle mistress and the returns start coming back to reality before long. It’s so embarrassing when I first got interested in the stock market, the NASDAQ was returning unbelievable returns. I bought into the whole ‘New Economy’ illusion.”
Later, I looked it up. The NASDAQ returned 40% in 1995, 23% in 1996, 22% in 1997, 40% in 1998, and an unbelievably crazy 86% in 1999. Then things fell apart. Now a decade later, the NASDAQ is trading at half of the all-time high established in early 2000.
“I think the most important lesson I have ever learned is to avoid the extrapolation error. I took a few data points from 1995-1999 and connected the dots. Even I didn’t think that 1999’s insane gains were sustainable, so I through them out as an anomaly but just assumed that stock market gains based on the four years prior were going to be indicative of future returns. Using a very select few data points to extrapolate future gains is NOT a very good investment strategy.”
Now, just a year later, I find myself sitting amongst what The Economist magazine has labeled the most overvalued property market in the world. The arguments for a housing bubble are supported by price to rent ratios, price to income ratios, very recent examples of what happened in the US, and common sense.
The arguments against a housing bubble are supported by the argument that people have said that property will crash, but it has continued to go up without taking the Greater Fool Theory and the Extrapolation Error into affect. People here say that Australia is different and the end game will have a different result than the US and other Western countries. However, every time someone says, “this time it’s different...” you know the result is going to be the same.
Shit. Things had been going so well to this point. I was pitching some things I had been working on and he was claiming he had some business opportunities. I didn’t put a whole lot of faith in getting a consulting engagement out of it. I had seen it a few times where he seemed pretty gung ho and got people working and researching a project only to see it go nowhere.
I was there to do my pitch as a dress rehearsal. If something came of it, great. If not, I wanted to keep my time commitment to an absolute minimum. Now it looked like I wasn’t the only one pitching. This is the last thing that I wanted.
I gave a very non-committal and disinterested answer. He was not deterred.
“I’ve started a hedge fund,” he said. This is the same guy, who just three years earlier, was an expert in Service Oriented Architecture. As co-workers, in the office together, it took me about ten minutes to realize that he didn’t know anything about Service Oriented Architecture. He had never seen an Entity Relational Diagram or have any knowledge of basic data modelling.
He continued, “Even in these difficult economic conditions, we have been giving our investors returns of 5-8%,” he paused for dramatic effect and then smiled, “PER MONTH.”
I nearly spit my drink out. A return of 6% compounded monthly would mean doubling money EVERY YEAR. 100% annualized returns simply do not exist. This was crazy talk. Santa Claus, the Easter Bunny, and the Tooth Fairy are far more real than 5-8% returns compounded monthly.
And yet... he seemed very sincere. “I can let you in on the friends and family program for just $25,000,” he offered.
At least I had an easy out. I politely declined siting my lack of $25,000 in cash. He left the line of communication open and said to give him a call if I changed my mind. I did a few hours of research on some of the other business we discussed and found, quickly, that it was a terrible idea.
I told Julie about the conversation and the 5-8% returns part. “How do you know he can’t do it?”
“Because when something is too good to be true - it is. Period. He seemed sincere and that’s the part that scares me the most. There are a few explanations for it, but none of them are sustainable.”
“He mentioned tracking currency exchanges going back one hundred years. The thing is, currencies from a hundred years ago have absolute no relationship to currencies from today. It’s like comparing Michael Jordan’s Bulls teams from the 1990’s to Derrick Rose’s Bulls of today. Both teams play in Chicago, but that’s all they have in common. They have different players and different coaches. Any statistics from MJ’s teams are completely out of context when comparing them to Rose’s team.”
“There are a couple of possible explanations, starting with this is a straight up Ponzi scheme. Basically, early investors get in on the ground floor. New investors come in flooding the fund with money, they claim the money is coming from investments, but it’s really funded by new investors coming into the fund. Everything is great for everyone, until the source of new investors dries up. This is exactly what happened with Bernie Madoff. Early investors who were smart enough to get out, made great returns. The new investors paid for the old investors, but anyone who didn’t cash out lost everything when it all came crumbling down. The Ponzi scheme is outright fraud and illegal. It relies on the illusion of legitimacy while acquiring new money. I don’t think he thinks he is defrauding anyone. It’s possible that he’s just the face and the illegal activity is happening behind his back without his knowledge. In fact, I’m willing to give him the benefit of the doubt.”
“It’s also possible that he’s doing technical analysis or day trading on momentum. Similar to the Ponzi scheme, this would be relying on the ‘Greater Fool Theory’. Essentially, a commodity - a stock, a property, a precious metal; continues to rise in price because it has been rising in price. As more and more people are drawn to this momentum, the price goes higher and higher. The good times continue as long as someone else - the greater fool, is willing to keep buying the commodity. When there is no greater fool, whoever is left holding the commodity loses everything. This happened with tech stocks around 2000 and housing prices from 2005-2008. The biggest difference between a Ponzi Scheme and the Greater Fool Theory is that speculative bubbles via the Greater Fool Theory are not illegal and are not outright fraud. Although... I’m sure investors in Pets.com would beg to differ.”
“The last possible explanation I am willing to accept is that weird and fluky things happen. Given enough time, the improbable but not impossible will happen. I remember playing in the Venetian Deep Stack and we were right on the bubble. Everyone was looking to bust the short stacks so we could all be in the money - it’s kind of an implied collusion that’s a part of the game. Someone with a very short stack goes all in and gets a caller. Ordinarily, anyone who can afford it and has a reasonable hand should just call and not re-raise. It should then be checked down to the river to give the best odds of busting the short stack. However, a guy goes all in on top of the caller and the whole table is pissed. Just a moment later, the raiser shows pocket aces and busts the short stack. Now we’re down to just one player left to bust before we all make the money. We’re going hand for hand with the other tables, so it takes a while before the next hand is dealt, but sure enough, a short stack goes all in, gets a caller, and the SAME guy goes over the top. Again, the table groans and he then shows pocket aces AGAIN and we all shut up and watch him bust the bubble.”
“Now most of us left are celebrating being in the money, but I’m stumped. Rather than being happy that I just cashed in my first major tournament, I try to figure out the odds of being dealt pocket aces twice IN A ROW. The odds of being dealt pocket aces on any given hand is 1:220. Therefore, the odds of being dealt aces twice in a row is 220 times 220. I whip out my iPhone and see that the odds are 1:48,400. It’s highly improbable, but it’s not impossible. I wouldn’t have believed it if I hadn’t seen it with my own eyes, but I assure you it did happen.”
“Back to this guy. It’s possible that plain old dumb luck is allowing for eye popping returns. But it’s nowhere near sustainable. Luck is a fickle mistress and the returns start coming back to reality before long. It’s so embarrassing when I first got interested in the stock market, the NASDAQ was returning unbelievable returns. I bought into the whole ‘New Economy’ illusion.”
Later, I looked it up. The NASDAQ returned 40% in 1995, 23% in 1996, 22% in 1997, 40% in 1998, and an unbelievably crazy 86% in 1999. Then things fell apart. Now a decade later, the NASDAQ is trading at half of the all-time high established in early 2000.
“I think the most important lesson I have ever learned is to avoid the extrapolation error. I took a few data points from 1995-1999 and connected the dots. Even I didn’t think that 1999’s insane gains were sustainable, so I through them out as an anomaly but just assumed that stock market gains based on the four years prior were going to be indicative of future returns. Using a very select few data points to extrapolate future gains is NOT a very good investment strategy.”
Now, just a year later, I find myself sitting amongst what The Economist magazine has labeled the most overvalued property market in the world. The arguments for a housing bubble are supported by price to rent ratios, price to income ratios, very recent examples of what happened in the US, and common sense.
The arguments against a housing bubble are supported by the argument that people have said that property will crash, but it has continued to go up without taking the Greater Fool Theory and the Extrapolation Error into affect. People here say that Australia is different and the end game will have a different result than the US and other Western countries. However, every time someone says, “this time it’s different...” you know the result is going to be the same.
