How stock pickers fiddle investment returns

The issue of whether to pay for stock picking advice boils down to two simple questions: First, does the company have a good track record in making money and second, can I believe their track record?

The answer to the first question, which is usually 'yes', is far less important than the second.

Why? Because there are many ways to make performance figures look good, and many investors don't have a clue what they are.

Intelligent Investor Share Advisor has been around for 16 years and we've seen all the tricks from come-and-go newsletter publishers to black box stock pickers. Almost all will claim to outperform the market. Far fewer will show how they've arrived at their figures.

Here, then, are the top six ways investment shonks hype up unsuspecting investors by polishing turds to make successful investing look easy, if only you pay them some money.

1. Not annualising returns – One company recently claimed an average gain of 41.1% from their ASX-listed recommendations over the past three years. Sounds pretty good, right? Trouble is, this figure was a simple average of a number of stocks over different time periods. We ran the numbers and the average annualised return was about 14%. Watch out for companies not annualising returns to make their numbers look bigger. A stock that doubles over 10 years isn't anywhere near as good as one that doubles in a year.
2. Assuming the future looks like the past – One recent headline from a stock tip sheet read, 'Does your investment strategy return over 20% annually? Ours does.' This insidious projection of the past into the future is misleading, creating unrealistic expectations about returns. Just because you made 20% last year doesn't mean you will next year.
3. Annualising small, short-term gains – This one's very popular. A company recommends a stock and quickly sells for a 7% gain in a month. They turn that into an annualised return of 125% by assuming the stock would have made 7% a month for a year. Here, the unscrupulous take the annualising principle and misuse it to bump up their numbers.
4. Not 'closing' recommendations – Companies reporting on their overall recommendations track record usually only include 'closed' recommendations – those stocks that have been sold. So how do you lift the average return figure? If you tell your subscribers to never sell, you can exclude the very worst recommendations from your calculations. By keeping the dogs as a 'Hold' the headline returns will look far bigger than they actually are.
5. Hyping up past gains – If the marketing blurb just features a few big winners but doesn't mention overall returns, that's a problem. Companies cherry pick recommendations for a reason, instead of providing figures on all the stocks they've bought and sold. Everyone has big winners, including the proverbial monkey and dartboard. A 300% gain in one stock means nothing until you see all the other recommendations that didn't go so well.
6. Telling investors what they need rather than what's realistic – Here's another example from a recent tip sheet email: 'We figure Australians need around a 15% return to fund a great lifestyle.' Pandering to what investors 'need' and not what is realistically achievable is like dangling an invisible carrot. Take it from me: achieving a 15% after-tax return over five years in a world of rock-bottom interest rates without taking excessive risks or leveraging up is very, very tough. As legendary Australian fund manager Don Brinkworth said, 'profits can be made safely only when the opportunity is available and not just because they happen to be desired or needed.'

By using the above techniques, it's easy to over-hype individual personalities and their stock picking skills. 'Prophet on the mount' syndrome preys on people's desire to find a (preferably charismatic) messiah to follow and venerate. But you'll generally find at least one and maybe more of these little tricks behind the performance figures they quote.

So how should you judge a company offering advice on what stocks to buy and sell? You've still got to look at their track record but if you find any of these techniques embedded in their calculations, think twice about using them.

And for the record, Intelligent Investor Share Advisor's performance is audited annually by accounting firm Grant Thornton. Between 1 June 2001 and 30 June 2014 we've generated annualised returns of 14.0% from 405 unique positive recommendations.