"Why we keep falling for financial scams"

Hello again,

There is a fairly good article in Monday’s Wall Street Journal called, “Why We Keep Falling For Financial Scams.” I wanted to excerpt a portion of the piece written by Stephen Greenspan (no relation to Alan) as a form of public service. Here goes…

“Financial scams are just one of the many forms of human gullibility — along with war (the Trojan Horse), politics (WMDs in Iraq), relationships (sexual seduction), pathological science (cold fusion) and medical fads. Although gullibility has long been of interest in works of fiction (Othello, Pinocchio), religious documents (Adam and Eve, Samson) and folk tales (“The Emperor’s New Clothes,” “Little Red Riding Hood”), it has been almost completely ignored by social scientists. A few books have focused on narrow aspects of gullibility, including Charles Mackey’s classic 19th-century book, “Extraordinary Popular Delusion and the Madness of Crowds” — most notably on investment follies such as Tulipmania, in which rich Dutch people traded their houses for one or two tulip bulbs. In my new book “Annals of Gullibility,” based on my academic work in psychology, I propose a multidimensional theory that would explain why so many people behave in a manner that exposes them to severe and predictable risks. This includes myself: After I wrote my book, I lost a good chunk of my retirement savings to Mr. Madoff, so I know of what I write on the most personal level.

…

“The basic mechanism explaining the success of Ponzi schemes is the tendency of humans to model their actions — especially when dealing with matters they don’t fully understand — on the behavior of other humans. This mechanism has been termed “irrational exuberance,” a phrase often attributed to former Federal Reserve chairman Alan Greenspan (no relation), but actually coined by another economist, Robert J. Shiller, who later wrote a book with that title. Mr. Shiller employs a social psychological explanation that he terms the “feedback loop theory of investor bubbles.” Simply stated, the fact that so many people seem to be making big profits on the investment, and telling others about their good fortune, makes the investment seem safe and too good to pass up.

“In Mr. Shiller’s view, all investment crazes, even ones that are not fraudulent, can be explained by this theory…

“While social feedback loops are an obvious contributor to understanding the success of Ponzi and other mass financial manias, one also needs to look at factors located in the dupes themselves. There are four factors in my explanatory model, which can be used to understand acts of gullibility, but also other forms of what I term “foolish action.” A foolish (or stupid) act is one in which someone goes ahead with a socially or physically risky behavior in spite of danger signs or unresolved questions. Gullibility is a sub-type of foolish action, which might be termed “induced-social.” It is induced because it always occurs in the presence of pressure or deception by other people.

“The four factors are situation, cognition, personality and emotion. Obviously, individuals differ in the weights affecting any given gullible act. While I believe that all four factors contributed to most decisions to invest in the Madoff scheme, in some cases personality should be given more weight while in other cases emotion should be given more weight, and so on. As mentioned, I was a participant — and victim — of the Madoff scam, and have a pretty good understanding of the factors that caused me to behave foolishly. So I shall use myself as a case study to illustrate how even a well-educated (I’m a college professor) and relatively intelligent person, and an expert on gullibility and financial scams to boot, could fall prey to a hustler such as Mr. Madoff.

“Situations. Every gullible act occurs when an individual is presented with a social challenge that he has to solve. In the case of a financial decision, the challenge is typically whether to agree to an investment decision that is being presented to you as benign but may pose severe risks or otherwise not be in one’s best interest. Assuming (as with the Madoff scam) that the decision to proceed would be a very risky and thus foolish act, a gullible behavior is more likely to occur if the social and other situational pressures are strong.

The Madoff scam had social feedback pressures that were very strong, almost rising to the level of the “Donators” cult around the Drake inheritance fraud. Newspaper reports described how wealthy retirees in Florida joined Mr. Madoff’s country club for the sole reason of having an opportunity to meet him socially and be invited to invest directly with him. Most of these investors, as well as Mr. Madoff’s sales representatives, were Jewish. The fact that Mr. Madoff was a prominent Jewish philanthropist was undoubtedly another situational contributor.

“A non-social factor that contributed to a gullible investment decision was, paradoxically, that Mr. Madoff promised modest rather than spectacular gains. Sophisticated investors would have been highly suspicious of a promise of gains as spectacular as those promised decades earlier by Charles Ponzi. A big part of Mr. Madoff’s success came from his apparent recognition that wealthy investors were looking for small but steady returns, high enough to be attractive but not so high as to arouse suspicion. This was certainly one of the things that attracted me to the Madoff scheme, as I was looking for a non-volatile investment that would enable me to preserve and gradually build wealth in down as well as up markets.

“Another situational factor that pulled me in was the fact that I, along with most Madoff investors (except for the super-rich), did not invest directly with Mr. Madoff, but went through one of 15 “feeder” hedge funds that then turned all of their assets over to Mr. Madoff to manage. In fact, I am not certain if Mr. Madoff’s name was even mentioned (and certainly, I would not have recognized it) when I was considering investing in the ($3 billion) “Rye Prime Bond Fund” that was part of the respected Tremont family of funds, which is itself a subsidiary of insurance giant Mass Mutual Life. I was dealing with some very reputable financial firms, a fact that created the strong impression that this investment had been well-researched and posed acceptable risks.

“I made the decision to invest in the Rye fund when I was visiting my sister and brother-in-law in Boca Raton, Fla., and met a close friend of theirs who is a financial adviser and was authorized to sign people up to participate in the Rye (Madoff-managed) fund. I genuinely liked and trusted this man, and was persuaded by the fact that he had put all of his own (very substantial) assets in the fund, and had even refinanced his house and placed all of the proceeds in the fund. I later met many friends of my sister who were participating in the fund. The very successful experience they had over a period of several years convinced me that I would be foolish not to take advantage of this opportunity. My belief in the wisdom of this course of action was so strong that when a skeptical (and financially savvy) friend back in Colorado warned me against the investment, I chalked the warning up to his sometime tendency towards knee-jerk cynicism.

“Cognition. Gullibility can be considered a form of stupidity, so it is safe to assume that deficiencies in knowledge and/or clear thinking often are implicated in a gullible act. By terming this factor “cognition” rather than “intelligence,” I mean to indicate that anyone can have a high IQ and still prove gullible, in any situation. There is a large amount of literature, by scholars such as Michael Shermer and Massimo Piattelli-Palmarini, that show how often people of average and above-average intelligence fail to use their intelligence fully or efficiently when addressing everyday decisions. In his book “Who Is Rational? Studies of Individual Differences in Reasoning,” Keith Stanovich makes a distinction between intelligence (the possession of cognitive schemas) and rationality (the actual application of those schemas). The “pump” that drives irrational decisions (many of them gullible), according to Mr. Stanovich, is the use of intuitive, impulsive and non-reflective cognitive styles, often driven by emotion.

“In my own case, the decision to invest in the Rye fund reflected both my profound ignorance of finance, and my somewhat lazy unwillingness to remedy that ignorance. To get around my lack of financial knowledge and my lazy cognitive style around finance, I had come up with the heuristic (or mental shorthand) of identifying more financially knowledgeable advisers and trusting in their judgment and recommendations. This heuristic had worked for me in the past and I had no reason to doubt that it would work for me in this case.

“The real mystery in the Madoff story is not how naïve individual investors such as myself would think the investment safe, but how the risks and warning signs could have been ignored by so many financially knowledgeable people, including the highly compensated executives who ran the various feeder funds that kept the Madoff ship afloat. The partial answer is that Madoff’s investment algorithm (along with other aspects of his organization) was a closely guarded secret that was difficult to penetrate, and it’s also likely (as in all cases of gullibility) that strong affective and self-deception processes were at work. In other words, they had too good a thing going to entertain the idea that it might all be about to crumble.

“Personality. Gullibility is sometimes equated with trust, but the late psychologist Julian Rotter showed that not all highly trusting people are gullible. The key to survival in a world filled with fakers (Mr. Madoff) or unintended misleaders who were themselves gulls (my adviser and the managers of the Rye fund) is to know when to be trusting and when not to be. I happen to be a highly trusting person who also doesn’t like to say “no” (such as to a sales person who had given me an hour or two of his time). The need to be a nice guy who always says “yes” is, unfortunately, not usually a good basis for making a decision that could jeopardize one’s financial security. In my own case, trust and niceness were also accompanied by an occasional tendency toward risk-taking and impulsive decision-making, personality traits that can also get one in trouble.

“Emotion. Emotion enters into virtually every gullible act. In the case of investment in a Ponzi scheme, the emotion that motivates gullible behavior is excitement at the prospect of increasing and protecting one’s wealth. In some individuals, this undoubtedly takes the form of greed, but I think that truly greedy individuals would likely not have been interested in the slow but steady returns posted by the Madoff-run funds.

“In my case, I was excited not by the prospect of striking it rich but by the prospect of having found an investment that promised me the opportunity to build and maintain enough wealth to have a secure and happy retirement. My sister, a big victim of the scam, put it well when she wrote in an email that “I suppose it was greed on some level. I could have bought CDs or municipal bonds and played it safer for less returns. The problem today is there doesn’t seem to be a whole lot one can rely on, so you gravitate toward the thing that in your experience has been the safest. I know somebody who put all his money in Freddie Macs and Fannie Maes. After the fact he said he knew the government would bail them out if anything happened. Lucky or smart? He’s a retired securities attorney. I should have followed his lead, but what did I know?”

“I suspect that one reason why psychologists and other social scientists have avoided studying gullibility is because it is affected by so many factors, and is so context-dependent that it is impossible to predict whether and under what circumstances a person will behave gullibly. A related problem is that the most catastrophic examples of gullibility (such as losing one’s life savings in a scam) are low-frequency behaviors that may only happen once or twice in one’s lifetime. While as a rule I tend to be a skeptic about claims that seem too good to be true, the chance to invest in a Madoff-run fund was one case where a host of factors — situational, cognitive, personality and emotional — came together to cause me to put my critical faculties on the shelf.

“Skepticism is generally discussed as protection against beliefs (UFOs) or practices (feng shui) that are irrational but not necessarily harmful. Occasionally, one runs across a situation where skepticism can help you to avoid a disaster as major as losing one’s life (being sucked into a crime) or one’s life savings (being suckered into a risky investment). Survival in the world requires one to be able to recognize, analyze, and escape from those highly dangerous situations.

“So should one feel pity or blame toward those who were insufficiently skeptical about Mr. Madoff and his scheme? A problem here is that the lie perpetrated by Mr. Madoff was not all that obvious or easy to recognize. Virtually 100% of the people who turned their hard-earned money (or charity endowments) over to Mr. Madoff would have had a good laugh if contacted by someone pitching a Nigerian inheritance investment or the chance to buy Florida swampland. Being non-gullible ultimately boils down to an ability to recognize hidden social (or in this case, economic) risks, but some risks are more hidden and, thus, trickier to recognize than others. Very few people possess the knowledge or inclination to perform an in-depth analysis of every investment opportunity they are considering. It is for this reason that we rely on others to help make such decisions, whether it be an adviser we consider competent or the fund managers who are supposed to oversee the investment.

“I think it would be too easy to say that a skeptical person would and should have avoided investing in a Madoff fund. The big mistake here was in throwing all caution to the wind, as in the stories of many people (some quite elderly) who invested every last dollar with Mr. Madoff or one of his feeder funds. Such blind faith in one person, or investment scheme, has something of a religious quality to it, not unlike the continued faith that many of the Drakers continued to have in Oscar Hartzell even after the fraudulent nature of his scheme began to become very evident. So the skeptical course of action would have been not to avoid a Madoff investment entirely but to ensure that one maintained a sufficient safety net in the event (however low a probability it might have seemed) that Mr. Madoff turned out to be not the Messiah but Satan. As I avoided drinking a full glass of Madoff Kool-Aid — I had invested 30% of my retirement savings in the fund — maybe I’m not as lacking in wisdom as I thought.”

*****

I will have further comment on this story soon, but for now I hope that you consider this food for thought.

Jason