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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.
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.
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?
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.
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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