Every great bull market hides some level of fraud, unbeknownst to its victims. Its unique in that the fraudster and the defrauded feel wealthier despite it being an illusion.
It’s Enron before everything blew up. The shareholders felt richer, as did Jeff Skilling and his cohorts, until it all unraveled.
The difference between real wealth versus illusory wealth is what John Kenneth Galbraith called “the bezzle.”
To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in—or more precisely not in—the country’s businesses and banks. This inventory—it should perhaps be called the bezzle—amounts at any moment to many millions of dollars. It also varies in size with the business cycle.
In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.
Fraud works better during long bull markets because of the almost consistent drip, drip, drip of good news. Earnings beats, record sales, and other announcements are consistent with a growing company. Multiple it by hundreds or thousands of companies doing the same and you get a bull market.
We miss it or overlook it due to a mix of trust, complacency, and greed. It’s easier to trust one company’s (undiscovered fraudulent) results, when so many others report similar good news. And the gradual rise in stock prices over time leads to a similar rise in complacency.
The same is true of Ponzi and other investment schemes. It’s easier to believe high returns are possible in the higher-than-average return environment of a bull market.
It’s only after the market collapses that the fraud and/or illusion is revealed. Until then, nobody really questions the returns.
Of course, one could argue that fraud is not a prerequisite for the bezzle. Charlie Munger did just that, with his own term “febezzle.” The “functional equivalent of bezzle” is alive and well in market bubbles, for example.
Munger calls it “crowd folly.” Investors pile into an asset class because other people are doing it, so prices rise. That creates a feedback loop that pushes prices higher and higher as more people pile in. The price has no relation to reality, but everyone feels richer in the moment.
Munger also compared it to investment companies that charge high fees for high returns that could be earned with a lower-cost option. Investors, I’m sure, are happy about the higher returns and feel wealthier, but the high fees to do more to enrich the investment companies than the clients. Especially, when those returns are more of a byproduct of a rising bull market than fund manager brilliance.
CEO’s exaggerated storytelling to meet stock price targets, corporate buying sprees of overpriced assets to keep earnings growth intact, and accounting changes and other (legal) shenanigans to keep the earnings beat party going are all examples of “febezzle.”
In all cases, a market crash unearths the problem. Be it overpriced assets, accounting shenanigans, or outright fraud, it all gets harder to hide in a falling market. The end result for investors is serious losses.
The bezzle and febezzle are two more reasons investors need to stay on their toes. It takes a healthy dose of common sense and a willingness to investigate. If it seems too good to be true, it probably is, is a good rule to follow. And the more complex the investment, the tougher the questions you should ask.
- Take advantage of the SEC’s EDGAR database for publicly traded companies. Go through past quarterly reports. Read the footnotes.
- Checkout any broker, advisor, or firm pushing an investment on you. Look up their history on FINRA’s BrokerCheck. Red flags are frequent complaints, disciplinary action, or past criminal record.
- Watch out for promises of high guaranteed returns, especially in a short time period. The only guarantee in investing is that every investment carries risk.
- The same is true for a history of consistent returns. For example, Madoff’s scheme showed consistent returns month after month going backed years. Consistent returns is an oxymoron when it comes to investing.
- Take a beat. Pushy “act now,” once in a lifetime opportunity tactics are also red flags. Good long-term investments will still be good long-term investments in a week or two. There’s no need to rush into it.
- If you’re still skeptical after asking all your questions but just can’t help yourself, size the position accordingly. The riskier the investment, the small the position is a good rule of thumb. More to the point, only risk what you’re willing to lose because you just might lose it.
In all cases, you should probably follow Buffett and Munger’s concept of a “Too hard pile.” If an investment is too complicated or too complex to understand, just outside your comfort level, or triggers your skepticism alarm bells, drop it in your too hard pile and avoid it.
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