Don't Fall for a Financial Magic Trick

Physician's Money Digest, October15 2004, Volume 11, Issue 19

Here's an easy but impressive magic trick foryour next party. Tell your guests that youhave been developing the power to controlothers' thoughts. When your guests start towonder if you have had too many drinks or are just losingit, offer to demonstrate your new power. Ask astrong-minded guest to think of a number between oneand five. After they make up their mind, ask them toannounce their number (eg, two). Say that it is exactlythe number you had selected before the party and forcedhim to think of. To prove the point, ask another guest tolift a particular vase to find a card underneath that says,"You will think of the number two."

The secret:

Before the party, prepare five cards witha different number from one to five on each. Then hidethem in five different places. When your guest announcesthe number, direct another guest to the card with thatparticular number. Your guests will think this is the onlycard you had hidden, and they will believe in your intuitivepowers. All magicians perform endless variations ofthis trick all the time. So before bringing it up, make surethat there isn't a magician in the audience.

Fund Company Tricks

Most of the investment management communityplays variations of this trick on us all the time, and we areso gullible that we fall for the same trick again and again.

How many times have you seen an ad by a mutualfund company showing that a few of their fundshave trounced the indexes by 5%, 10%, or more peryear over some time period? We're routinely impressedby the ads and pour money into these funds,only to regret it later.

What the fund companies don't tell us is that theyhave hundreds of funds, of which these were the bestperformers over the particular time period. Chances are,most of their other funds did much worse than theindexes over that time, and even the advertised funds didmuch worse than the indexes in other periods.

In the magic trick, the magician does not tell theaudience that there are several other cards hidden; likewise,the fund companies do not draw our attention tothe fact that they are showing us only the best examplesfrom a much larger, hidden group.

Morningstar Ratings

Often, similar ads are accompanied by five-star ratingsfrom Morningstar instead of their past returns todazzle and mislead us. Here we are being tricked in twodifferent ways. First, we aren't being shown the star ratingsof the many other funds of the company or of theadvertised funds in other periods—presumably becausethose ratings are not that great.

Second, what do those star ratings mean? Theydon't mean much if we're interested in figuring outhow well a fund is likely to do in the future.Morningstar is a company that does an excellent job ofproviding data and analyses of mutual funds. It developedthe star rating system to measure the historicalperformance of a mutual fund relative to other similarfunds, taking into consideration risk and return.

But this has almost no predictive power. Just becausea fund did well on this measure in the past, it doesn'tmean it will perform well in the future. Morningstarknows it and clearly says so. But the fund companiesknow that if they can show five stars next to the name ofa fund, many investors will be impressed and buy thefund. So the fund companies frequently choose to misleadby giving us only partial information—not very differentfrom magicians or most other advertisers.

Chandan Sengupta, author of The Only Proven

Road to Investment Success (John Wiley; 2001)

and Financial Modeling Using Excel and VBA

(John Wiley; 2004), currently teaches finance at

the Fordham University Graduate School of

Business and consults with individuals on financial

planning and investment management. He welcomes

questions or comments at chandansen@aol.com.