The Wolf of Wall Street: 2 Key Lessons for Everyday Investors

Martin Scorsese's new film, The Wolf of Wall Street, premiered in the U.S. yesterday. The film, starring Leonardo DiCaprio and Jonah Hill, has been well received by critics, garnering a 77% rating on review aggregator site Rotten Tomatoes.

The film, based on the real-life exploits of convicted white collar criminal Jordan Belfort, turns securities fraud and market manipulation into a depraved comedy.

While this topic has been explored in the past in films such as Wall Street (1987) and Boiler Room (2000), most films in the genre tend to stick with a general theme -- that these high-rollers were pretty clever, but felt sorry that they got caught.

The Wolf of Wall Street. Source: Theguardian.com

Yet for individual investors, films like The Wolf of Wall Street offer two important lessons that should not be overlooked.

Lesson #1: Stop paying financial advisors and fund managers to lose your money.

Many people who don't understand the stock market hire so-called "experts," such as financial advisors and fund managers, to manage their hard-earned cash.

"Thanks for letting me take care of your money -- and paying for my yacht." Source: Cinemotion.com

The sobering truth is that in 2012, nearly two-thirds of all U.S. mutual funds underperformed the S&P 500. Performance over the past 10 years is even worse -- less than 20% of actively managed diversified large-cap mutual funds have outperformed the S&P 500 over the last 10 years. Pretty dismal.

The reason is simple -- mutual fund managers aren't magical black boxes powered by advanced AI algorithms. They are flesh-and-blood stock pickers who try to reduce risk by diversifying a fund's portfolio across more than 60 or 70 stocks.

For example, you might be happy to find out that your mutual fund owns shares of Starbucks (NASDAQ: SBUX  ) , which rallied 47% over the past year. Unfortunately, that might not mean much for you, since Starbucks might only account for less than 1% of the entire fund. At the same time, your fund might also own shares of J.C. Penney (NYSE: JCP  ) , which plunged 56% over the past year.

Hedge funds, which are mutual funds that require a minimum investment of $1 million, aren't any better. The Hennessee Hedge Fund Index, the most widely used method of tracking the cumulative performance of hedge funds, currently has an 11.2% year-to-date return, considerably underperforming the S&P 500's 28.6% gain.

In addition to underperforming the market, mutual and hedge funds charge additional fees that can offset those meager gains. Mutual funds, on average, charge a year-end fee of 1.5%.

If you are paying these guys to manage your money, you might want to consider one of these two options instead -- simply invest in a handful of well-known S&P 500 stalwarts such as Starbucks, Disney (NYSE: DIS  ) , and Nike (NYSE: NKE  ) , or invest in a passive index fund that simply tracks the S&P 500.

Both options would have produced higher returns over the past year -- so why pay someone to lose your money instead?

^SPX Chart

Source: Ycharts.

Lesson#2: If it's too good to be true, it probably is.

Jordan Belfort made hundreds of millions of dollars through a "pump and dump" penny stock scam. This is different from the older (and more illegal) method of selling shares of non-existent companies, since the companies that Belfort's firm persuaded investors to invest in were all real companies.

Penny stocks are stocks that trade under $5 in the over-the-counter market, and not through one of the national exchanges, such as the NYSE or NASDAQ. Since the market capitalization, stock price, and daily volume of these stocks are quite low, they are highly vulnerable to being manipulated. For example, a sudden large volume purchase or sell could cause the price to pop or drop by triple-digits in a single day.

Belfort's "pump and dump" idea was simple -- have his firm accumulate shares of these thinly traded companies, stash the shares into secret accounts, and "cold call" investors to convince them that these companies were potential multi-baggers. The influx of buy orders would rapidly inflate the price, convincing investors that the stock was rallying.

However, it was just an opportunity for Belfort's firm to unload its shares at a huge profit. Once Belfort unloaded his position, the stock plunged and demand dried up as investors trampled each other to dump the plunging stock. Belfort was eventually convicted in 1998 for securities fraud and money laundering, and sentenced to 22 months in prison for defrauding investors of $200 million. Belfort was only ordered to pay back $110.4 million.

Source: Dailymail.co.uk.

Today, there are plenty of websites and newsletters recommending penny stocks. Unscrupulous firms out there are still trying to replicate Belfort's "pump and dump" model.

The best defense for everyday investors against these financial predators is to remember two things:

  • If a firm really believes that a stock will shoot to the moon, they won't likely share that information with you via a phone call or email.

  • Understanding simple stock market fundamentals, such as market capitalization, volume, revenue, and earnings growth can help everyday investors weed out these potential scams and find solid investments.

A final thought

People looking to invest their money usually consider three options -- do it themselves, invest in a passively managed index fund, or pay a money manager to do it for them.

History, however, suggests that the first two options are clearly better than the last one.

What do you think, dear readers? Does the inclination to trust "experts" more than ourselves put millions in the pockets of people like Jordan Belfort? Let me know in the comments section below!

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  • Report this Comment On December 26, 2013, at 11:29 AM, normanando wrote:

    I saw the film last night. Your advice as to who shall be responsible for investing our money is sobering and honest. This story was about the sad degradation of all relationships the financial industry and prostitution exploits. So when unbridled greed takes over human being for material wealth and external success it is a bottomless pit, & what appears as cause for "celebration" was only attempting to medicate all the suffering of our humanity.

  • Report this Comment On December 27, 2013, at 3:21 PM, patski1 wrote:

    The advice for all investers should be simple and clear:

    If you do not understand how a company is making money and how much money it made, how much it keeps, and where it goes, then it is not an investment for you...it is a gamble. Maybe someone else does understand the company's "revenue model" but if you do not - do not invest.

    If the company is not distributing any of its income to its shareholders in the form of dividends, it is not an investment...it is a gamble. You are gambling that this company will gain value over time. Now, that may be a good gamble but until you sell the stock, you aren't really getting anything from your money and the future value of the company is in hands other than yours. That is harsh, but it is true. Make sure that you are comfortable with this reality

    Mutual funds are constrained by self dealing and herd mentality. They all talk to each other and they all do essentially the same things at the same times. That is what causes the rise and fall of the exchanges. When everyone buys, the price goes up and when everyone sells, the price goes down. You cannot make a profit doing what everyone else is doing at the same time that they are doing it.

    Mutual funds are operated for their own benefit, not yours. The 2% management fee is taken from the gross assets, not the income, of the fund and they get that fee whether or not the fund goes up or down.

    If you can count to 100 without assistance and have read this far, you can probably do basic investment without the management fees. Buy stocks directly. Don't go fancy. Invest in companies that produce products that you like or provide services that you use, so long as they have existed for at least 5 years and produce a dividend .The rest is all blue smoke and mirrors

  • Report this Comment On December 28, 2013, at 3:35 AM, Mayssa wrote:

    Today DSS daily stock select has recommended NKE as new target price with (85.37$) who else gonna buy?

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