The accounting scandals involving
WorldCom, Enron, and others derived from the data being selected, spun, and
filtered. A scam I first discussed in my book Innumeracy derives instead from the recipients of the data being selected, spun, and filtered.
It goes like this. Someone claiming to be the publisher of a stock newsletter
rents a mailbox in a fancy neighborhood, has expensive stationery made up, and
sends out letters to potential subscribers boasting of his sophisticated
stock-picking software, financial acumen, and Wall Street connections. He writes
also of his amazing track record, but notes that the recipients of his letters
needn’t take his word for it.
Assume you are one of these recipients
and for the next six weeks you receive correct predictions about a certain
common stock index. Would you subscribe to the newsletter? What if you received
ten consecutive correct predictions?
Here’s the scam. The newsletter
publisher sends out 64,000 letters to potential subscribers. (Using email would
save postage, but might appear to be a “spam scam” and hence be less credible.)
To 32,000 of the recipients, he predicts the index in question will rise the
following week and to the other 32,000, he predicts it will decline. No matter
what happens to the index the next week, he will have made a correct prediction
to 32,000 people. To 16,000 of them he sends another letter predicting a rise in
the index for the following week, and to the other 16,000 he predicts a decline.
Again, no matter what happens to the index the next week, he will have made
correct predictions for two consecutive weeks to 16,000 people. To 8,000 of them
he sends a third letter predicting a rise for the third week and to the other
8,000 he predicts a decline.
Focusing at each stage on the people
to whom he’s made only correct predictions and winnowing out the rest, he
iterates this procedure a few more times until there are 1,000 people left to
whom he’s made six straight correct “predictions.” To these he sends a different
sort of follow-up letter, pointing out his successes and saying that they can
continue to receive these oracular pronouncements if they pay the $1,000
subscription price to the newsletter. If they all pay, that’s a million dollars
for someone who need know nothing about stock, indices, trends, or dividends. If
this is done knowingly, it is illegal. But what if it’s done unknowingly by
earnest, confident, and ignorant newsletter publishers? (Compare the faithhealer
who takes credit for any accidental improvements.)
There is so much complexity in the
market, there are so many different measures of success and ways to spin a
story, that most people can manage to convince themselves that they’ve been, or
are about to be, inordinately successful. If people are desperate enough,
they’ll manage to find some seeming order in random happenings.
Similar to the newsletter scam, but
with a slightly different twist, is a story related to me by an acquaintance who
described his father’s business and its sad demise. He claimed that his father,
years before, had run a large college-preparation service in a South American
country whose identity I’ve forgotten. My friend’s father advertised that he
knew how to drastically improve applicants’ chances of getting into the elite
national university. Hinting at inside contacts and claiming knowledge of the
various forms, deadlines, and procedures, he charged an exorbitant fee for his
service, which he justified by offering a money-back guarantee to students who
were not accepted.
One day, the secret of his business
model came to light. All the material that prospective students had sent him
over the years was found unopened in a trash dump. Upon investigation it turned
out that he had simply been collecting the students’ money (or rather their
parents’ money) and doing nothing for it. The trick was that his fees were so
high and his marketing so focused that only the children of affluent parents
subscribed to his service, and almost all of them were admitted to the
university anyway. He refunded the fees of those few who were not admitted. He
was also sent to prison for his efforts.
Are stock brokers in the same business
as my acquaintance’s father? Are stock analysts in the same business as the
newsletter publisher? Not exactly, but there is scant evidence that they possess
any unusual predictive powers. That’s why I thought news stories in November
2002 recounting New York Attorney General Eliot Spitzer’s criticism of Institutional Investor magazine’s analyst awards were a tad
superfluous. Spitzer noted that the stock-picking performances of most of the
winning analysts were, in fact, quite mediocre. Maybe Donald Trump will hold a
press conference pointing out that the country’s top gamblers don’t do
particularly well at roulette.
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