Why We Should Beware of “Proprietary Strategy”

Just a few days ago – almost right after Valentine’s Day – the infamous Ponzi scammer Bernard Madoff which I mentioned in a previous post “The Curse of the Pyramids”, made it to the headlines again in a New York Times interview when he claimed that “the banks were complicit in his scheme to steal billions of dollars.” Wow, I got struck… what a piece of news bursting with topics to write about. And here, I got preempted to make good a promise to write something about a closely related issue.

The key phrase “banks were complicit” sounds too tempting to take up but let us just ignore this phrase for the meantime (we will have ample time to take this up in the future when we go back to credit cards issue). Let us just focus on another key phrase attributed to Madoff, not in that recent New York Times interview, but in another interview made years back.

To refresh our minds, I mentioned in the post “The Curse of the Pyramids” that in 2001, Madoff was questioned in an interview with Barrons about his methods or secrets for having double digit returns for his investors. Madoff said that it was “proprietary strategy” and there, probably, was an air of magnificence and awe, if not magic, for people who heard him. Pressed for details, Madoff simply said “he can’t go into details”. No further questions.

Well, “proprietary strategy”, that is the magic word. In the rarefied world of finance and investment, fortunes have been made and lost on the altar of this magic word (more lost than made, of course). Fortunes made on the part of the “strategy authors” and fortunes lost on the part of the participants who joined the schemes, trusting blindly that such “strategy” will bring them to financial nirvana of sorts.

No further questions. What an ironclad shield. In a courtroom scene, it is as if a trial lawyer cannot proceed further in his questioning of a witness and hence, has to yield and say “no further questions, your Honor.”

Let us disabuse our minds and see here the reasons why we should beware of this phrase. As I mentioned in an earlier post, if we hear an investment solicitation pitch to such effect, it is better to get lost as quickly as possible. Here are the reasons:

One, this phrase is the favorite refuge of scoundrels of which Madoff is the epitome. And why not, the phrase is a blanket expression so powerful in squelching questions and curiosities. Hence, the corollary phrase “can’t go into details”.

Two, this phrase is the very antithesis of the principle of “simple and understandable”- as passionately championed by the greatest mentors of value investing: Benjamin Graham and Warren Buffett. Here we have to mention again Buffett’s no.1 criterion for a business to invest in: the business should be simple and understandable. And for Benjamin Graham: “In my 44 years of Wall Street experience, I have never seen dependable calculations of common stock values or related investment policies that went beyond simple arithmetic or the most elementary algebra.”

Three, common sense plainly demands that investment strategies are to be disclosed to give comfort to the investor. Hence, it is the practice for mutual funds and other investment schemes to reveal, at least in broad terms, the investment strategies being pursued. Any investment strategy that hides information, let alone the strategy being pursued, is simply suspect. In finance parlance, this is a “red flag”, a reason for anybody to beware.

Four, in a strict sense, this is not investing but plainly gambling. Remember the three elements of “investment” in the post “Is Gambling a Sort of Investment and Investment a Sort of Gambling”? The first element is “analysis” or study, the second element is the promise of the “protection of principal” and the third is “adequate return” or promise thereof.

That these elements are simply not existent here is something that is obvious. Here, there is simply no analysis or study as the participant abjectly surrenders everything to something that is “proprietary” and known only to the schemer.

This brings us to the realm of gambling. The first element is the risking of money or valuables on the outcome of a game, contest or event; the second element is that the event is partially or totally dependent upon chance.

One who participates in the scheme is simply risking on something that is dependent upon chance. And what is the chance? Well, the chance is two-fold: first, that the promoter of the proprietary strategy is not a scammer and, second, that he indeed or his group is capable of getting high returns (a very tall order). That is gambling plain and simple.

Now, you my ask whether, it is possible that there is such a thing as “proprietary strategy” that really works. Well, probably there is. I am open to such possibility and this probably is something related to arbitrage (difference in price in different markets at the same time) opportunities in some foreign currency trading areas.

Also, I have heard of fantastic returns in options, futures and other financial concoctions. But I have heard more about investment banks and hedge funds (a higher risk mutant of mutual funds) collapsing. It is precisely due to such financial concoctions that America is still reeling from crisis where many economists outside of the US government conjure an eventual doomsday scenario.

My advice to OFW investors and would-be investors? Steer clear of such financial concoctions and be literate in investment. Beware of “proprietary strategy” like the plague.