Investing and Trading: Risks, Fraud, Investor Behaviour, and Technical Tools

Part I: Investing Behavior

In general, there are three types of investors / traders: those who have a very low tolerance for risk, those with a moderate tolerance for risk, and those with a very high tolerance for risk. According to the online questionnaire that I completed, I am a very high risk investor, and this was a finding that did not surprise me. At this point in my life, I would like to try for a very high return on any investment that I make, and the potential of losing money does not bother me as much as it should. Generally speaking, my current attitude toward money is that if I lose some, I can always make more, or cut back on my personal budget to save more.

As for investments that would appeal to me, and that any financial advisor would recommend for someone with my high level of tolerance for risk, these would be stocks, real estate securities, currencies, crypto, high yield bonds, and options. All of these types of investments are considered to be high risk, but can also yield some very good returns when they are successful. However, my financial advisor would probably advise me of the importance of diversifying my investment portfolio, and would recommend that I only place about 50 to 60 percent of my total amount slated for investment into such high risk funds. She or he would most likely recommend that I place about 30 to 40 percent of my assets into medium risk investments, such as real estate, low volatility small cap stocks, and convertible bonds (De Bortoli et al., 2019). The remainder should be placed into relatively low risk investments, such as mutual funds and bonds. Through diversification of my portfolio, and spreading the risk level around, this will help to provide some protection if there is an economic crisis, or the high risk investments do not perform as well as expected.

While this high risk investment portfolio may be ideal for me at this point in time, this is likely to change as a get older. As people advance into middle age, their financial goals tend to change--they are likely to have children that they want to send to college, and are trying to purchase a home or to pay down the mortgage on a home that they already have. Moreover, people start to become more worried about their lives in retirement, and will most likely want to make investments that are much more medium risk. Even if an investor has a low tolerance for risk, they should be encouraged to take on mid-level risk investments in their thirties and forties, since they are still most likely bringing in income, and can shoulder any potential losses. However, if an investor is nearing retirement age, or is already in retirement, they will most likely want to go for low risk investments, since they are at a point in their lives in which they cannot weather financial losses in the stock market, and need to keep their capital intact as much as possible.

Part II: Recognizing Fraud

A pyramid scheme is a business or investment model in which the earliest investors are asked to recruit more participants and get them to invest money. As the "pyramid" grows, the money that is collected from the newest recruits is then used to pay dividends to the earliest investors, or the people at the "top of the pyramid." However, nothing is actually invested in, nor are any real products sold. As for me, I have never participated in or invested in such a scheme, but I was once aggressively recruited by a family friend who was a sales representative for Mary Kay Cosmetics, which is a multi-level marketing scheme. At one point in time, I had been laid off from my job, and this friend knew I was looking for work, and started to tell me all about how well she had done selling Mary Kay cosmetics. Initially, I believed her, since she owned a beautiful house in an upscale neighborhood, and drove a late model BMW. However, once she began to fill me in on the details of what I had to do, I started to feel that I was being scammed.

As for getting involved in selling Mary Kay cosmetics, this "friend" told me that I would have to invest over $1,000.00 in a "starter kit," and then go around trying to sell makeup and skin care products to my friends. I was also told that I could make the most money my convincing my friends to purchase starter kits of their own. I was incredibly skeptical, as I myself do not care for Mary Kay cosmetic products, and do not know many people who do. I just did not believe that there was that much demand for Mary Kay cosmetics out there, so I decided to do a bit of independent research. According to Helene Olen (2012), writing for Forbes, "the company promises their recruits riches, but everything from class action lawsuits to SEC filings reveals that for most sellers, it rarely works out that way. What's really going on is that would-be saleswoman are encouraged to invest in "product" by other saleswomen, who will then get a cut of all resulting purchases. Not surprisingly, most end up with little more than credit card debt and boxes of rapidly expiring make-up for their troubles." Fortunately, I did not fall victim for this scheme (and asked this "friend" to never contact me again), but I can see how many people might fall for it.

Often, it can be difficult to detect a pyramid scheme because the perpetrators often present themselves as "investment" or "financial professionals," and often make it sound as though they are investing in actual assets or selling an actual product. The victims of these scams can truly be anyone, but more often than not, the victims tend to be the elderly or unsophisticated. These schemes are unsustainable because the only revenue that is being generated is money from new investors or participants. Once people stop investing or spending money, there is nothing else being generated, so the "pyramid" collapses. What follows is a diagram of a pyramid scheme.



Figure 1. Pyramid Scheme Diagram (United States SEC, 2020).

Part III: Famous Scandals

The person who discovered the Ponzi scheme of Bernie Madoff was Harry M. Markopolos, another financial professional who kept hearing from clients that one of his competitors was consistently delivering high returns. Markopolos thought this sounded too good to be true, so he decided to investigate the matter, and found multiple inconsistencies in the financial statements of Madoff's company. As for the structure of the pyramid scheme that Madoff created, Kenton (2020) describes it thusly: "Despite claiming to generate large, steady returns through an investing strategy called split-strike conversion, which is an actual trading strategy, Madoff simply deposited client funds into a single bank account that he used to pay existing clients who wanted to cash out. He funded redemptions by attracting new investors and their capital, but was unable to maintain the fraud when the market turned sharply lower in late 2008. He confessed to his sons-who worked at his firm but, he claims, were not aware of the scheme-on Dec. 10, 2008. They turned him in to the authorities the next day. The fund's last statements indicated it had $64.8 billion in client assets."

Surprisingly, many of Madoff's victims were fairly sophisticated investors, and most of them were quite wealthy, which allowed for the success of the scheme for a prolonged period of time. Since many of the newer investors were spending millions of dollars to enter into the "investment," Madoff was able to pay handsome dividends to his longer-term investors, making the scheme appear to be legitimate. Moreover, he was actually a legitimate financial professional with a long history of success and a strong reputation on Wall Street, and so his victims truly had very little reason to doubt his claims, or to think that he would have any motivation at all to try and scam them, since he was quite wealthy himself.

As for his own defense, Madoff basically blamed his victims for wanting to get rich quick, and seems to have genuinely believed that he could deliver on his promises had he been allowed to stay in business long enough. As for regulatory biases that contributed to this problem, it is clear that no one thought that Madoff could possibly be a threat to anyone, since he was already a well established financier and trader, and had substantial assets of his own (Henriques, 2018). As for why legislators and Congresspeople focused their attention on the Securities and Exchange Commission, this is because it is clear that there were multiple "red flags" throughout the entirety of the Madoff Ponzi scheme that should have made regulators sit up and take notice. However, the SEC seems to have just assumed that, because Madoff had a strong reputation, he was incapable of any wrongdoing.

Part IV: Technical Trader Tools

Nowadays, there are literally thousands of technical tools available to traders and investors. The goal of these tools is to predict a future price action of a trading equity. Some of them work in a traditional way where a human manages all aspects of trading. However, computer models and AI are destined to take over most, if not all, functions of trading. Nevertheless, all trading techniques and instruments have derived from the "old school" tools, like the Dow Jones Theory, the Elliott Wave Theory, or the Wyckoff Method. Some of these tools or theories have been improved and are still successfully used today, while others have been forgotten. New analytical tools get invented or discovered almost every day. However, most of them bring nothing new to the analysis because they are based on an already-existing concept.

References

De Bortoli, D., da Costa Jr, N., Goulart, M., & Campara, J. (2019). Personality traits and investor profile analysis: A behavioral finance study. PloS one, 14(3).

Henriques, D. B. (2018). A case study of a con man: Bernie Madoff and the timeless lessons of history's biggest Ponzi scheme. Social Research: An International Quarterly, 85(4), 745-766.

Kenton, W. (2020, Feb 5). Bernie Madoff Investments. Investopedia.

Olen, H. (2012, Jul 20). Mary Kay Preys on Women. Forbes.

United States Securities and Exchange Commission. (2020). Pyramid Schemes. investor.gov.