Pat Huddleston, author of The Vigilant Investor: A Former SEC Enforcer Reveals How To Fraud-Proof Your Investment talks to Commitmentnow.com about the natural tendencies and wiring in our brain that can leave us vulnerable to scam artists. He explains: "Everyone with a healthy human brain is vulnerable... I’ve represented multi-millionaires, blue-collar retirees, and all kinds of people in between. And they all — across that vast economic spectrum — had one thing in common: they all thought that they were too smart, savvy, or sensible to fall for a fraud. They had not yet discovered how important it is to be able to think about their own thought processes, and cognitive biases led them straight to financial ruin."
Commitmentnow.com: What are some of our natural human tendencies that leave us vulnerable to investment fraud artists?
Pat Huddleston: First, it’s important to remember that these tendencies result from the wiring of our brain. Every healthy human has these tendencies. Psychologists call them cognitive biases. They are natural and well-worn paths of thought.
There are many biases that make us vulnerable, but two of the culprits are the optimism bias and the congruence bias. The optimism bias tells us that disasters, including financial disasters, happen to other people, but not to us. It’s this bias that leads us to think that the victims of a scam must have been gullible, greedy, and/or stupid. Because we are none of those things, we feel immune to fraud.
And, of course, if we’ve ruled it out as a possibility, we take no precautions against it.
The congruence bias thwarts the efforts of investors who set out to do their own investigation of an investment. To understand the congruence bias you first have to appreciate that, as a matter of efficiency, our brain suggests a theory to explain any new situation. The congruence bias leads us to accept evidence that proves that theory and reject or minimize evidence that disproves it.
So, if our working theory is that an investment is legitimate, the congruence bias will lead us to accept confirmation of legitimacy and reject or explain away evidence to the contrary.
That’s why I counsel people not to look for legitimacy, but rather to look for fraud. If fraud is what you want to avoid, you have to look for it.
Commitmentnow.com: What are some ways to spot an investment fraud artist?
Pat: First, it’s important to know that investment fraudsters don’t look like a stereotype. They aren’t fast talking hucksters. People described Bernie Madoff as having a “quiet confidence.” He wasn’t pushy. He was even a little reluctant to accept new investors.
A competent scam artist will give you no red flags in the presentation. None. That’s what makes them so dangerous.
But people are still at risk from inexperienced or marginally competent scamsters who haven’t learned the game well enough not to give themselves away. Those characters may be pushy, using high pressure. Certainly, people should never invest in something that involves a high-pressure pitch.
Pressure is designed to make your mind race and prevent careful consideration. So, reject out of hand anything sold through pressure. Even if the pressure is not overt, stay away from it.
Sometimes scamsters will say that the window for investment is closing and that you must make a decision by a certain date or be precluded from investing. Stay away from those as well. There is no legitimate deadline. The deadline is purely a sales trick.
If you don’t have time for a thorough investigation, put the investment permanently out of your mind. We cover additional sales tactics in the book, but I don’t want to overload you with this answer. If you think space allows it, let me know and I’ll talk about a couple more.
Commitmentnow.com: What are some ways fraud artists will earn the trust of people they are out to scam? What emotions and belief systems will they play on to earn trust and gain access to money?
Pat: It’s important to go back to our brain wiring. We sometimes give too much credit to the scamster. The truth is that the victim’s brain does most of the heavy lifting. The successful scamster just hitches a ride on the victim’s neural pathways. It isn’t a matter of keeping emotions in check.
While emotion is present in response to certain sales pitches, it isn’t the emotion that’s to blame. It’s best to think of the emotion as coincident to the brain wiring that is the real culprit.
With that caveat, we often see people lose money to what the SEC calls “affinity fraud,” which is fraud that targets members of an identifiable group. Sometimes it is a religious group. Sometimes the group is occupational. Sometimes it’s a hobby. The central ploy of the scamster is to make himself look like a member of the group. People trust no one so much as they trust themselves.
So, if a scamster can make himself look like his intended victims, they are less likely to suspect a fraud. We’ve seen affinity frauds that target Christians, Mormons, Jews, and Muslims. We’ve seen frauds that target retired bus drivers, Ferrari owners, the deaf, the blind, and immigrants from many nations. We also see cultural affinity frauds. One of the examples in the book involves a scam that targeted Italian-Americans in Chicago.
Commitmentnow.com: How can adult children protect their elderly parents from unscrupulous investment advisers? Why are older people so vulnerable and often the target of investment scams?
Pat: I’ll take the second part first. Older people are vulnerable, first, because they are human, and all humans are vulnerable. But older people are more vulnerable because of the cognitive decline that comes with aging. Studies show that we peak in our ability to evaluate investments at age 53 and that 35 percent of people over the age of 71 suffer from a condition called Mild Cognitive Impairment (MCI) midway between the changes that typically accompany aging and full blown dementia.
Two of the symptoms are impulsiveness and poor judgment. So, already, more than 8 million Americans go into their financial decisions with impulsiveness and poor judgment, and the population is aging rapidly (the leading edge of the baby boom generation turned 65 in May).
But, again, everyone, regardless of age, who doesn’t learn more about how the brain works in the investment context, is vulnerable.
Adult children can protect their parents by talking to them about the risk in a way that creates a partnership between child and parent for their mutual protection. What you want is to make yourself a resource on which the parent agrees to rely.
If that effort goes well, you can get the parent’s records reviewed by a competent attorney or accountant (someone without an interest in managing the money), who can tell you whether the investments are properly diversified and the risk level appropriate to the investor’s age and investment goals.
But, even if the parent takes offense at the conversation and thinks that the child is being greedy and just wants control over the parent’s finances, at least they will be more aware of the danger than before.
The only unacceptable course is to do nothing. Your parents are already the target of reckless brokers and financial scamsters. The chances of any senior citizen with assets avoiding their gaze are nil.
Do not kid yourself that scamsters might leave your parents alone or that your parents are too smart to fall for a scam. If you decide not to talk to your parents about this, you are choosing to put them in the path of a financial predator who is sure to visit them.
Commitmentnow.com: Can you describe the Golden Boy and the Thief, and some of the other archetypical types of people who engage in investment fraud?
Pat: There are lots of different ways to slice and dice these characters, but I divide them into five categories in the book.
The Golden Boy is usually in his early thirties. He has, or he fakes, very impressive credentials – Ivy League school, impressive work on Wall Street – and he seems to have the Midas touch. He is charismatic without being smarmy and very good in front of an audience. He tends to live on the lavish side; custom tailored suits, luxury cars, and a house much bigger than his family requires. He’ll often have a luxury box at the local stadium. He’ll give to charity in a way that draws attention.
The Thief is a smash-and-grab criminal. There is very little craft in what he does. He simply forges documents and signatures to get your money, and then leaves the country. Advisers who have never been in trouble sometimes become thieves in the wake of a mid-life crisis or some other traumatic life event.
The Fibber, who I sometimes call the Bad Report Card Fraudster, is scary because there are so many of him. Bernie Madoff was a Fibber. Everything goes well until he loses some of your money. Rather than send you an account statement that shows that loss (a bad report card) he fabricates a statement that shows a modest gain, figuring that he’ll bring everything back into balance when things turn around next quarter.
When things don’t turn around, what began as (they believe) a modest lie turns into a full-fledged Ponzi scheme. He gets so far behind that he stops rationalizing that he’ll ever be able to make things right. You might be surprised how many Fibbers go to Las Vegas in hopes of winning big enough to get things back to even.
The Bungler believes that he’s a terrific stock picker, but he isn’t’; he’s incompetent. Psychologists have found that competence and the ability to recognize competence go together. The Bungler can cause a lot of damage because he lacks the capacity to appreciate how bad he is at his job. These guys often morph into Fibbers.
Finally, we have the Career Criminal. There are thousands of these guys operating all around the world. They go from scam to scam. If they go to prison, they use every day of incarceration to plan the scam that they’ll start as soon as they get out. You are only safe from them when they are in prison.
Commitmentnow.com: Is everyone vulnerable to fraud? Aren't some people just too smart to get scammed or deceived?
Pat: Everyone with a healthy human brain is vulnerable. I like way you asked the question because it allows me to distinguish between intelligence and wisdom. I’ve represented multi-millionaires, blue-collar retirees, and all kinds of people in between. And they all — across that vast economic spectrum — had one thing in common: they all thought that they were too smart, savvy, or sensible to fall for a fraud. They had not yet discovered how important it is to be able to think about their own thought processes, and cognitive biases led them straight to financial ruin.
Studies show that people who have more education and more financial knowledge are actually more likely to fall for fraud than less educated people. So, it isn’t smarts that matters, but wisdom.
I am sure that someone (I can’t remember who) said it long ago: The smartest person is the one who appreciates how little he knows. People who are wise enough to admit their vulnerability have many more defenses than the person who figures that his or her natural intelligence is enough.
It would be funny if it weren’t so tragic, but the I’m-too-smart-to-fall-for-it attitude is exactly the attitude that every scamster wants his prospective victims to have. It makes them such easy pigeons to pluck.
Commitmentnow.com: How did Madoff con so many people who were normally very intelligent and savvy themselves? What techniques did he use to persuade some of America's wealthiest to invest in his scheme?
Pat: See above. They were intelligent and savvy, but not yet clued in to the impact of their brain wiring. The CIA’s Center for the Study of Intelligence teaches CIA analysts about this wiring. Analysts learn that they must be knowledgeable about their own mental processes if they want to see things accurately. If they don’t account for cognitive biases, they will see whatever those biases lead them to see. And the same is true for investors.
Madoff used at least two tools that are common to many successful scams. First, he created an aura of exclusivity around his funds. Not just anyone was allowed to invest. People like thinking of themselves as members of exclusive clubs, and were, therefore, drawn to Madoff like Homer Simpson to a donut.
Second, he ‘delivered’ reasonably good, but not eye-popping returns. His legitimate competitors often produced better returns. But Madoff’s phony returns were more consistent and less volatile, and people began to prefer what they thought of as a guaranteed good return over the volatility of market leading returns in some quarters and big losses in other quarters.
This brings out perhaps one of the most dangerous misconceptions that people have about scams. People hear about the Nigerian email scams – the ones where a Nigerian general or prince wants to borrow your bank account for a few days to move vast sums out of the country – and they come to think of those as representative of the larger population of financial scams.
But the people who run those scams are the guys who flunked out of scam school, the absolute bottom of the scam artist talent pool, the far left of the scam artist competency curve.
The median competency investment fraudster would never go within a mile of a scam like that, would never offer to double your money, or make any other promise that sounds too good to be true. So the not-yet-vigilant investing public is on guard against the scams they are least likely to fall for and completely defenseless against the most dangerous and most prevalent types of scams.
Commitmentnow.com: What type of credentials, history, licensing, education, account or brokerage statements, and court record searches should a person look for and demand to determine if their adviser is legitimate?
Pat: First, they should not rely on anything they receive from the adviser; it’s too easy to create convincing forgeries. They should ask about all undergraduate and graduate degrees earned. And they should ask about all licenses held.
After getting those representations, they should go to the National Student Clearinghouse (www.studentclearinghouse.org) to find out about educational credentials. They should get a Central Registration Depository (CRD) report from their state securities commissioner to find out about securities licenses, and they should call any other professional licensing authorities (Board of Accountancy, Bar Association, etc.), to confirm representations about professional licenses.
They should also use pacer.gov to search federal court dockets for prior lawsuits, criminal convictions, and bankruptcies. Beyond that, they should do a docket search at the county courthouse where the adviser lives to check on state civil or criminal matters. There are other resources that we use in our investigations, but they are not readily available to the public.
Commitmentnow.com: Tell us about ‘the giveaway’ and how this is a scam that is often used in difficult economic times. Why does it work?
Pat: The giveaway scam prospers in difficult times because it plays on economic desperation. It takes years to run, but can be quite lucrative. It begins with the gathering of contact information by telling people that they qualify to receive a free amount of money from a group that has created a new economic paradigm.
People are obviously skeptical of that claim, but all the scamsters ask for is your name, home address, and email address. They don’t ask for your date of birth, your social security number, your mother’s maiden name or any other security information. People think, “they could get that information off of the Internet, so what’s the harm?”
People send in their information, with little more expectation than they have when they buy a lottery ticket, and receive the address of a website where they can keep track of the company’s efforts to begin paying the promised riches.
As people read more and more about the prospects for this group, they become more invested in the truth of it. They begin to follow supposed developments closely and are very excited when it is reported that the money will begin to flow within thirty days.
Eventually, the people behind the scam put out word that there is a tariff of some kind that must be paid before the money can be transmitted from overseas. Everyone who has signed up is asked to send a relatively modest amount compared with what they believe they will receive.
So they send in $300 (or whatever is specified). The group reports payment of the tariff, only to report that there are legal fees associated with the transfer and each person will need to send in another $150. Some portion of those who sent in $300 will also send $150, and another $100, and another $50, until they finally realize that the whole two-year production was a scam intended to rob them of whatever they were willing to send. If the group gathered 100,000 names and receives, on average, $200 from each victim, they make off with $20 million.
Commitmentnow.com: Why should a person never invest solely based on positive press releases, increasing trade volume and rising stock prices?
Pat: Because doing so puts you at risk of falling into a “pump and dump” scheme. The people behind such scams gain control of the shares of a worthless publicly traded company and then issue false press releases while pumping up the volume and price through pre-arranged trades with their cohorts.
The market data and the press releases make it appear as if the stock is destined for the stratosphere. When the scamsters believe that they have pumped the stock price as high as possible, they stop trading the stock back and forth between themselves and start selling it to unsuspecting investors. They take their loot and leave for another town and another pump and dump scam.
With the artificial volume gone, the stock tanks. Buyers of the stock find out too late that the company was no more substantial than the buildings on a Hollywood sound stage.
Commitmentnow.com: What are your best ten tips for those who want to protect themselves from investment fraud? What should they do to protect themselves, what questions should they ask, and what are some tip offs that maybe what they are being told isn't true?
1. First and foremost, learn about cognitive biases and learn to account for them in your investment decisions.
2. In your investigation, don’t look for confirmation of legitimacy; instead, look for fraud.
3. Always call your state securities commissioner to find out whether the broker is licensed in your state. If not, report it and stay away.
4. Be wise enough not to think that you are too smart to fall for a fraud.
5. Never invest with someone you know only via the Internet or over the phone.
6. Never invest under pressure; if you don’t have time to do a full investigation of the opportunity you can’t afford to risk the investment.
7. Confirm educational credentials and professional licenses; resume inflation is rampant in the investment industry.
8. Avoid investments that encourage investors to recruit family and friends.
9. Never write a check directly to your broker or to a company that he or she controls.
10. Alert your parents to the dangerous investing landscape and offer to be a resource to protect them.
To buy The Vigilant Investor click here.
About the Author: Pat Huddleston is the author of The Vigilant Investor; A Former SEC Enforcer Reveals How to Fraud-Proof Your Investments due to be published in October of 2011. He is the CEO of Investor's Watchdog, a due diligence company that conducts pre-investment investigations on brokers, RIAs, and unregistered investments. Investor's Watchdog has conducted investigations for clients all over the world and helped save millions in retirement savings that otherwise would have been lost to cleverly disguised frauds. Pat blogs on investment scams and investor protection issues every weekday at investorswatchdog.com. You can follow him on Twitter where his handle is scamdemic.