People Knowingly Pay for Useless Financial Advice

Posted on June 17th, 2012 by admin in Behavioral Finance, How to Invest

There is a classic scam in the investment world that always has a high return for the scammer. First, the scammer sends an advertisement to a set of  targets. The ad simply says something like “We are good at predicting the stock market and we want to serve you. To help you get to know us, we think Stock XYZ will be up  by Date.” Next, the scammer sends the identical note to another set of targets, but this time, the ad says that XYZ will drop  by Date.

After each mailing, the scammer sends another similar set of predictions, but only to those targets which received what turned out to be the correct prediction. After several rounds, there are a few targets who have received a string of correct predictions. Now, here’s the money shot: the scammer sends one more note, but this time says “We are sure you have enjoyed receiving our great advice so far. But now you have to buy our service get our next prediction.”

This process very cleverly identifies a pool of targets from which some will finally pay.

We assume this process has many illegal components. But mutual fund and hedge fund companies are notorious for using this exact technique in reverse to calculate their overall returns. They exclude funds from the calculation that were previously closed due to losses!

The common characteristic of the scam is that it purposefully misleads people. It now turns out that people will actually buy bad advice even when they know the advice cannot be valid–if it comes from an “expert”! Using a technique similar to the scam above, two academics Nattavudh Powdthavee and Yohanes Riyanto, of the Institute for the Study of Labour, published a paper in May 2012 showed by experiments that people would pay for advice they witnessed in real-time was wrong. We provide their original published paper here.

The authors write in their introduction:

Our paper focuses on a situation in which there is true randomness and predictions are transparently useless. In this setting of non-existent expertise, can an average individual be convinced to switch from having the correct belief that “outcomes are independent and predictions are inherently useless” to the false belief that “predictions provide useful information about the future” – thus leading them to buy subsequent predictions in the future– if they had recently observed a streak of perfect predictions being made in front of them live? We found that the answer is yes and that the size of the error made systematically by people is large.

Here’s the set up. The researchers used undergrads in Thailand and Singapore. They told the students they had to make bets (using tokens) on five rounds of coin flips, and that the coins came from other students. Also, to provide strong assurance to the subjects that the flips and coins were really random, the coins were changed after each flip, the flippers themselves were changed after each round, and the flippers would be participants as well.

At the separate cubical of each participant, there were five envelopes each containing a prediction of the outcome of a future flip. The student had a choice of paying to see an envelope in advance, or waiting for the outcome of the flip and then seeing the prediction for free. The students that paid for the prediction were allowed to see both the outcome and the prediction after the flip.

The key characteristic of all the predictions was that they were randomly generated. Thus, even for a sequence of correct predictions, they were known to be pure luck. The authors write:

Did people who randomly received correct predictions perceive in a hot hand of the nonexistent expert and in turn pay for such useless information later? If so, how long was it before they started buying? The answers are: yes, and not long.

They go on to conclude:

The first is that observations of a short streak of successful predictions of a truly random event are sufficient to generate a significant belief in the hot hand of an agent; the perception which also did not revert even in the final round of coin flip. By contrast, the equally unlikely streak of incorrect predictions also generated a relatively weak belief in the existence of an “unlucky” agent whose luck was perceived to be likely to revert before the game finishes; evidence which was reflected in an increase in the subject’s propensity to buy in the final round of coin flip.

It is well-documented that well over 90% of active fund managers produce returns no better than their target indexes, but people buy services from them anyway. Now we have data indicating people will pay for advice even when they know specifically it will be no better than chance.

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