Gleaning Investment Wisdom From a Magician Turned Skeptic

After "magically" escaping from this predicament, James Randi went on to teach audiences to be skeptical. His lessons apply to investing, too. Photo by Ron Burton/Getty Images.

"No matter how smart or how well-educated you are, you can be deceived."

Words of wisdom from an investment guru? Perhaps the lamenting of an SEC lawyer investigating a fraud case? Or a former stock manipulator who, since exposed, has come clean?

The answer is none of the above, but that makes the warning no less important. In fact, they are courtesy of James Randi, a magician-turned-skeptic who offers some of the most valuable investment lessons I've come across. How so? Randi is an expert in human nature, and I would argue the mastery of this skill is no less valuable to an investor than it is to a conjuror.

Some might recall "The Amazing" Randi from his national TV appearances hanging upside down in a straitjacket over Niagara Falls, submerged in a sealed metal coffin or locked in a safe. And he might have continued on that path indefinitely while his reputation as Houdini's worthy successor grew. But then it all changed for him.

"I know of no calling which depends so much upon mutual trust and faith as does ours," Randi once observed, though one could say investment advice isn't far behind. Realizing his deceptive powers could be used to manipulate people desperate for miracles brought him to a fork in the road. And fortunately for us he chose the path of advocate for the victims.

For investors to benefit from Randi's wisdom, it's necessary to take note of his core insight:

"If we're not disciplined, patient and thorough investigators, our propensity to want to believe things too good to be true will get us into a heap of trouble."

And we will typically not be more cautious even if presented with contradictory evidence! While the tendency is to think this happens only to others, accepting that human nature makes us susceptible is a critical first step.

Below are seven Randi-inspired telltale signs of too-good-to-be-true to keep in mind. If we look out for them, our chances of becoming better investors go up dramatically.

• Growth Without Risk. We all know reward without risk is like calorie-free cake and therefore unobtainable. But sometimes we ignore this truism or third-party warnings, and take comfort because more sophisticated individuals are involved. Bernie Madoff, former executive chairman of the National Association of Securities Dealers (a precursor to FINRA, brokers' self-regulatory agency), promised investors positive equity-like returns year in and year out, with no negativity ever. Prominent high net worth individuals and celebrities took the bait-and it eventually cost them billions. R. Allen Stanford promised CD-like volatility with equity-like returns. ATM Leaseback con artists promised 20% returns guaranteed. Sadly, there are countless other examples of Ponzi schemes and the like.

• Unrealistically Great Past Returns. We often base decisions on stories about the past. Randi has identified numerous examples of susceptible people paying vast sums for miracle cures based on the testimony of the provider. In investing, firms can similarly tout past returns they never actually achieved, while brokers and advisers can present "past returns" using hypothetical or cherry-picked data. Heck, we frequently see other investment firms packaging a collection of high-performing funds as their "strategy," boasting of the funds' recent returns even though they didn't recommend them until now and never actually achieved those returns for their own clients. Others use products that didn't exist until recently, claiming back-tested hypothetical performance shows they'll generate great results. They are imaginary. Yet we have a tendency to chase heat without first asking the tough questions, separating fact from fiction, understanding strategy and approach, or paying attention to the need for diversification.

• It's On TV. As it turns out, we're much more likely to believe something if we see it on TV, even though media fact checking can be poor and we don't get to see what happens off camera. Randi once tested his ability to make a "spirit-channeler" named Carlos credible, in part by releasing a press package listing a series of sold-out performances. Even though Randi made up the dates, the venues didn't exist and Carlos was actually somebody else, not one reporter questioned him. In investing, how people and theories are presented can greatly impact our understanding of them. We don't know what the reporter didn't ask. This is why it is so crucial not to take a common theme as gospel-always investigate and independently verify.

• Experts. Just because someone is introduced as an expert, it doesn't necessarily make them one. As Randi has suggested, not only is it perfectly okay to ask magicians how often they pull the wrong card, but the evidence is frequently right in front of us. For example, famed Illusionist Uri Geller used to be widely known for bending spoons with his mind. He even got a panel of scientists to certify his "powers"! But his spoon-bending tricks used to be explained on the back of cereal boxes. As Randi put it, "Either scientists don't eat corn flakes or don't read the backs of boxes." Similarly, many investing pundits, newsletter writers and others offer up a slew of forecasts that usually begin with some sort of credibility-builder-a description of their wonderful history of success. Don't take their word for it. Look at the cereal box. Do your own research. The fact of the matter is no financial professional with any longevity in this business is right all the time-even the best are wrong about a third of the time.

• Who Gains? Randi recommends we ask ourselves what presenters stand to gain if we believe them. So the next time a pundit proffers advice, it pays to notice whether that person is trying to sell us something like a book, a trading system or a newsletter subscription. It's also worth investigating the current holdings of presenters: Are they pushing a stock they already own? Are they bashing a stock they've already shorted?

• Fearmongering. In addition to asking ourselves what motivates presenters, Randi suggests we identify how they might be trying to manipulate our fears and vulnerabilities. The next time you hear someone claim the sky is falling, massive risk lies ahead or this time it's different, check your immediate reaction. Does the pitch induce panic? The urge to do something immediately like go to cash and ask questions later? If so, we need to recognize the symptoms, walk away, calm down, and take our time to do the appropriate research first, because when it comes to investing, panic is often our biggest enemy.

• Charisma. According to Randi, "The public really doesn't listen when they are being told straightforward facts. They would rather accept what some charismatic character tells them than really think about what the truth might be." Investing is no exception, as some of the great swindlers have the ability to lure people in because they seem so understanding, credible and ethical. The aforementioned Allen Stanford, who is serving a 110-year prison sentence for his transgressions, was able to convince wealthy Latin Americans to trust him by preying on their fear of unstable governments. Marc Dreier, a former lawyer serving 20 years for investment fraud, maintained a constant presence at high-profile charity events to garner public credibility. And so on.

Randi has gone on record to say he isn't a non-believer in the paranormal, just a skeptic who believes claims need to be backed by facts. Likewise, there are a number of reputable individuals providing investment advice, some of whom may be charismatic experts with excellent long-term historical results. The key is to take a skeptical stance upfront, then evaluate systematically and thoroughly. If you can keep this discipline in mind, you have a much better chance of navigating the complexities and information overload surrounding you, and ultimately achieving your investment goals.