The investment lesson from a US hard rock band

What was the idea behind this? As Daniel Simons and Christopher Chabris write in Nobody’s Fool: Why We Get Taken In and What We Can Do about It: “His logic was that if the organizers failed to follow such a simple instruction, they shouldn’t be trusted to have safely installed all of the rigging, wiring, staging, lighting, and pyrotechnics for a complex show.” And if the organizers failed the brown M&M candy test, the band paid more attention to the staging of the concert. As the authors point out: “Van Halen’s rider was what scientists might call a positive control, an extra experiment that checks whether everything is working as it should.” The point being that it wasn’t possible for the band to check everything for themselves before a live show. At the same time, the candy test was better than taking the assurances of the local organizers at face value. As Simons and Chabris point out: “Simple checks are never perfect, but blind acceptance is a terrible alternative.”

This example has an investing lesson in it as well. But before we understand that we need to understand something termed as the truth bias. As Cass R. Sunstein, an American legal scholar, writes in an essay: “People tend to think that what they hear is truthful, even if they have excellent reason not to believe what they hear.” Now this makes sense primarily because of two reasons. First, most of us are speaking the truth, most of the time. Second, it’s evolutionary. If human beings start questioning everything and anything, most of what keeps life going—the everyday decisions and transactions we make—would unravel pretty soon. Nonetheless, the truth bias—trusting what we are being told—hurts us when during the course of investing we become victims of a scam or even a misleading sales proposition.

Take the case of individuals who end up investing in Ponzi schemes which promise very high rates of return. A Ponzi scheme is an investment fraud where the first round of investors are paid using money being brought in by the second round of investors and so on. It keeps running until the money being brought in by the investors into the scheme is more than the money leaving it, and when the situation reverses, the scheme collapses.

In almost all these cases investors get focused on the high rate of return, believe that the return will be delivered and end up investing in the scheme. In that sense they become victims of the truth bias. Of course, there is no way that they can completely verify every piece of information they come across regarding the investment scheme. That’s not possible. But they could do what Van Halen did. Carry out a simple check before investing. And what would be this simple check? It can be a simple question to the individual selling the scheme: “How are you offering such a high rate of return in comparison to everyone else?” Just this thought would make sure they don’t invest in the Ponzi scheme.

Or take the case of what many wealth managers and relationship managers do these days. They pass off investment-oriented insurance schemes or even equity mutual funds as schemes which offer guaranteed returns. A simple way to deal with this situation is to ask where does the guarantee appear in writing.

The moral of the story as Simons and Chabris put it is, “Accept less, check more,” especially when it comes to investing one’s hard-earned money.

Vivek Kaul is the author of Bad Money.