It’s a quote by Charlie Munger:
The world is not driven by greed. It’s driven by envy.
And complement this with another one (I am not sure of its origins):
Return of capital is more important than return on capital.
The first quote is the root cause of perhaps all irrational adventures that investors are willing to undertake in their desire to beat competing standards of living.
The second quote is the perfect antidote to any irrational envious behaviour.
In the absence of the antidote, investing driven by envy is deadly. It compels you to chase high and fast returns. In my experience, almost all such adventures result in huge wealth destruction.
Here’s what else envy does. It forces you to junk any sane asset allocation plan that could otherwise be a safeguard that prevents you from total wealth destruction.
Let’s spend a moment and understand what 2% returns per month actually means. It amounts to an annualized return of 26.8%. Let that sink in. 26.8%. How does this compare to, let’s say, one of India’s favourite mutual fund schemes over the last five years —Parag Parikh Flexicap Fund? It earned only 23.4% per annum, over this period. Another popular fund, HDFC Flexicap, returned just 19.0%.
Other than the fact that 2% per month returns amounts to an irrational return expectation, there’s another big issue with this. The return is paid out every month. So, not only does the person offering this scheme, promise a crazy return when soliciting funds, he also assures to pay it off month after month. Whether the markets are up, or down.
At this point you are probably wondering how someone could fall for this scam. The fact is many did.
This is how the alleged “scam” played out.
The protagonist is a star trader, who claims to generate “risk free returns” (from the agreement) in the commodities market.
“Each month”, based on net gains generated in the prior month, the investor’s share of profits will be paid out within a clearly specified date range.
Here’s the clincher—“safety of principal funds invested is assured by…” the star trader’s firm (apparently, this is a sole proprietorship, so in essence the star trader stood assurance himself).
The combination of “risk free returns”, “each month” and “safety of principal funds invested is assured”, all mentioned in the agreement with the clients, is unbeatable. Who can match that?!
Add to these claims a track record of actually delivering a return of 2% per month, and you have a flywheel effect when it comes to pulling in money.
How did our star trader pull this off in the initial years? Well, he was probably running a ponzi scheme, i.e., paying off the 2% per month, or part of it, from the capital invested in the fund, and the new money that was rushing in. At some point in time, it was probably impossible to pull this off any further, and so, it blew up.
If you are thinking American financial criminal Bernie Madoff, you would be bang on. But then Bernie at least put up a pretence of a serious operation. Our star trader was, as I am told, operating all alone, in a tiny office in a Mumbai suburb. And in case you were wondering, he was not even registered with market regulator Sebi.
There were red flags at every stage. However, as long as the 2% per month return kept coming in, apparently no one worried about their 100% of capital. Sometimes you want to believe you have found the chicken that keeps laying golden eggs. Even though you know this does not really happen in real life.
In the end what we have is a situation where people have lost a lot of money. Some a large chunk of their life’s savings. Sad.
Who’s to blame? I leave that to you to decide.
Here’s what one should do to avoid getting caught up in such a scheme.
First, always remember if it’s too good to be true, it probably is. Anytime someone pitches you an idea that offers the potential to make an irrationally high return (like our star trader, and including some PMS schemes, structured products, thematic funds, etc.), up your guard big-time.
Second, always stick to your asset allocation. If you stick to your well-designed asset allocation plan, you will always have downside protection. This should take care of your long-term wellbeing (even if you fall for such a scheme). Don’t violate the plan and make a bigger bet than your plan permits.
Third, if you really want to take a punt with a star trader, go back to our concept of play money. That way you can stay busy, and popular (at parties), but at no point in time put your family at risk just for some envy driven misadventure.
In the end, a gentle reminder. Investing is simple, but not easy. Stick to the simple stuff, persist with it. And remember, the two quotes, which I restate here:
The world is not driven by greed. It’s driven by envy.
Return of capital is more important than return on capital.
If you walk this path, it may be long, but it will be potentially very rewarding. With the added bonus of having side-stepped the extremities of any unnecessary misadventures.
Happy Sensible Investing.
Rahul Goel is the former CEO of Equitymaster. You can tweet him @rahulgoel477.
You should always consult your personal investment advisor/wealth manager before making any decisions.