Vol 3, Issue 12. Quarter 2 – 2026. 

Consider the human side of the thief. Let’s look at the story of a short guy from Brooklyn. Just for fun let’s call him Ernie. Ernie is a young investment analyst looking to start his own asset management business, handling portfolios for high net worth individuals. Many of these folks believe that there is some way to “beat the market”. They think that they just need to find the right young fellow with a “new” system or formula that will get that done.

Ernie has a nice system that he has worked up. It involves collar style options. Where you buy a call option that pays when the stock price rises and a put option that pays when the stock price falls. You also hold the stock so that you get the dividends and price appreciation that in total should average about 10% per year over the long term. Of course, you have to shop carefully for the options and buy them at the best point in time to minimize costs and get a bit more of an edge. You also lean one way or the other, meaning that you think the price is more likely to rise (or fall) based on your own projections. This starts to get quite complicated, and hard for the single investor to understand, but you don’t expect huge gains in any single period – just reduced variance without sacrificing the upside. By the way, this is pretty much the selling point of most complex financial products sold to small do it yourself investors.

Our friend Ernie has only one problem at this stage. He has a good job, but no clients of his own. He solicits investment from friends and family, but most of them don’t have huge amounts of capital to put at risk using his unproven strategy. Ernie eventually gets around to asking a couple of people that he didn’t really want to deal with – his in laws. With the help of his wife, he eventually gets them to put in a few hundred thousand dollars and he is off and running. Now Ernie has two big problems. First, if he loses his mother in law’s money he will never hear the end of it. Second, his brilliant strategy loses money in the first quarter with the new capital. Fortunately (he thinks) for him the loss is less than the bonus he expects to get from his main job. To keep the peace in the house he decides to fake an account statement, make up for the loss out of his own pocket and tell the in laws that they saw a reasonable 10% annual return over the period.

Then disaster strikes. Ernie’s strategy actually makes money. You may ask, “how is this a bad thing?” The answer is that now Ernie starts to think that he actually knows what the hell he is doing. With this new found confidence he solicits much more aggressively and talks the in laws, along with many of their friends and business contacts to add to the pile. Here comes the trap. Ernie loses much of the money in the next quarter. However, he firmly believes that his strategy will eventually turn around and make the money back. After all, it worked in the last quarter, and the long-term return of the strategy should be about 10% right?

Here is the trick bag. If Ernie generates accurate account statements, he is doomed. Furthermore, he suspects that his mother in law will compare her statements with those of her friends. Now Ernie sets out to create a set of fake statements for the entire group. As soon as the strategy actually turns a profit he can make good on the accounts and play it straight from there. The only catch is that Ernie will have a real problem that he cannot dance around if anyone asks for all of their money back too soon. The only way to insure against this is to get new money into the fund. Armed with statements showing two or three quarters of nice, smooth returns of almost 1% per month. He finds that it is amazingly easy to get that new capital.

Now the trap is spung. Ernie sits in his office with a full year of beautiful statements to show. People are throwing money at him faster than he can count it. And no one even asks how it is all done. They are so happy with this “performance” that he gets everything he ever wanted. Money, a happy wife, lots of “friends”, invitations to the finest country clubs, restaurants, and charity benefits. He is invited to speak at conventions, meetings, and universities. He gets to be the humble, self-made man who hangs out with the rich and famous. And best of all – he gets – – respect!

About a decade or so later some nerds start snooping around. They see that the volume of options that had to be traded to make Ernie’s stated strategy work at the needed scale were never actually executed. Almost perfect 10% returns at this scale could not have been generated the way that Ernie says they were.  Now he has two options. One, he can come clean, take the blame, go to jail, and get on with life or, two, he can double down. He can bring in more money, create more exotic options, make more fake statements, and let the courts handle the mess in probate after he dies. Of course, he chooses the later.

To avoid detection the entire operation is being run out of a small office that very few people actually see. Statements are made using simple spreadsheets and generated using old dot matrix printers that can’t store files or images. It’s also a bit easier to cover things up because Ernie is running a legitimate business in the rest of the building. It produces a reasonable profit, employs the rest of his family, and pays its taxes on time and is in compliance with all of the relevant regulators.

One day, we see a mortgage crisis. The world goes crazy. The market values of everything collapses all at once. Clients panic and scream to pull their money out.  Since the money doesn’t exist, the gig is up. Bernie, I mean Ernie goes to jail and dies there a few years later.

I suspect that most of you missed the main point of our little story. Of course, we can all say that Ernie was a greedy no-goodnik. Nothing new there. No, the REAL key to all of this is that Ernie never promised great returns. He didn’t even fake making huge returns when he easily could have done so. His gimmick was to fake the absence of variability. Showing 10% returns on average is pretty easy. In fact, getting 10% returns is not that hard if your horizon is long enough. But showing that return with no variance is simply impossible. Stock markets pay you a 10% return to compensate you for dealing with the variance. What is amazing here is that his clients were happily willing to ignore all common sense as long as he displayed an absence of uncertainty. Many of these investors were very successful, very rich, and some had decades of experience in equity investing. But when someone told them that their wildest dream had come true, they bought any story they were told.

The English philosopher David Hume became famous arguing that the more extraordinary a claim is, the more extraordinary the evidence must be before you accept it.  Some people refer to this as Hume’s Law. Well its time you met Chester’s Law.

The more you wish something were true, the more extraordinary the evidence must be before you accept it even if you don’t think the claim is extraordinary.  

This is true because you subconsciously devalue evidence that contradicts what you DON’T want to believe and elevate any evidence that seems to validate what you DO want to believe. That is why the bar has to be incredibly high before you accept a claim that you wish were true.

Unti that happens YOU need your own plan that YOU understand and that YOU implement, regardless of how mediocre your plan is. Without that, you run the risk that the next Bernie Maddoff that comes along finds you before we do.