Spotting Phony Investment Secrets

I’ve written previously about what I think are the best investment strategies for young people (well worth another read), but this is a topic that needs rehashing. Especially as the country approaches the fiscal cliff (automatic decreases in government spending and increases in taxes that could harm consumer demand), people are anxious about the stock market. And because people are anxious, they are prone to making some poor decisions.

What’s the problem with people being anxious about the markets? Well, for one, they might be tempted to pay large premiums for “expert advice”—even though they would be better off passively managing their money. That is, instead of turning to an expert who promises to get them large returns in uncertain times (but fails), they could be putting their money in low-cost index funds and earning a higher, more consistent return.

There are other problems with fears about market conditions: People are more likely to buy at peaks of the market—when conditions seem to be going great—and to bail out of it at the bottom—when things seem as if they could not be going worse. The problem is then, of course, that people are buying high and selling low; they are losing a lot of money on their purchases by getting scared, instead of letting the market build back up. And that is just one mistake that people make with stock trading in times of uncertainty.

Even if you do not fall prey to the above problems with anxiety, it is still important that you can spot phony investment secrets. They will be prevalent over the next few months, and you should do your best to tune them out. Here are two recommendations:

1. If a strategy claims to consistently beat the market, especially by large margins, be very suspicious.

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It is incredibly unlikely for an individual investor to outperform the stock market consistently year after year. Consider what that would mean: They would need to have superior information (or luck) to the people around them to be able to consistently turn a profit on trades.

That information advantage is difficult, of course, with the rise of near-instant computer-initiated trades, 24/7 news coverage of economic trends, and the general democratization of stock-trading (companies like Schwab and E*Trade come to mind). It is incredibly difficult to beat the market because the market reacts almost instantly to incorporate public information into its pricing conditions.

For example, you might think that Coca-Cola is underpriced because the company has planned an expansion into some new line of drink for next year. But if that announcement has already been made publicly, then the market has reacted to that expectation and incorporated it into the price. The room for profit has been pushed out.

It is certainly possible for funds and investment strategies to beat the market in a given year, but that trend is very unlikely to repeat itself over time. Past performance can only indicate so much about a fund; there is always a component of luck and volatility involved, and you might not want to expose yourself to those risks. Instead, you should probably just take a passively-managed route and be content to grow with the market. In the end, you’ll likely earn better returns for it anyway.

2. Consider why somebody is willing to sell the secret to you.

If somebody truly came across a formula that could consistently beat the stock market, they would be sitting on a goldmine. Keeping the information private would let them turn considerable profit for themselves without fear—because they supposedly know how to beat the market. So, why would they be willing to sell you this incredible secret?

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For one, if the secret were real, selling it publicly would effectively ruin the secret’s efficacy. Because of the aforementioned market dynamics where public information influences stock prices, people could likely only exploit the system to a small degree before it caught up. This catch-up effect is true for the formula’s creator as well, but releasing the information to other people would speed up the adjustment.

In other words, if it became public knowledge that certain stocks were undervalued according to a foolproof formula, the stocks’ prices would rise. The market would adjust, and the opportunity for profit would be gone. Just by being publicly available, it is unlikely that the strategy will really return great profits.

Of course, there are some publicly-known investment strategies that do work out great for consumers—the passively-managed index funds, for example. But in those cases, the funds are overlooked because they don’t play into eye-popping advertising gimmicks or people’s drive to outperform the market. They also are not promising to exploit some faulty market dynamic for profit, but merely to grow with the market.

With the investment tips that are marketed online—and not just by random people, but by well-known names such as MSNBC’s Jim Cramer and Forbes’s Ken Fisher—you have to wonder why they would give away such lucrative information. Perhaps they are just being generous, but more likely they’re looking to develop a sales relationship with you or to earn profit somehow from your trades (this should not be read as specific accusations of Cramer or Fisher, whose intentions I cannot know with certainty). Either way, you should be hesitant to put your money in the funds. If the offer sounds too good to be true, it probably is.

You have the capacity to invest wisely for the future, even in uncertain times. What matters is that you remain calm and do not let fear-mongering salespeople influence your decisions. Those people very often have agendas that do not align with your interests, and it helps to be able to spot them and to think about why their secrets likely do not work. Armed with that information, you are far more prepared to make sound investment decisions.