Be On Your Guard
We humans would like to assume that when we find ourselves in an unclear or unfamiliar situation we use our own brain power to work our way out. And that might be true if we find ourselves alone in that situation. But as soon as we have others around us, our brains get lazy. Instead of thinking for ourselves we look at what everyone else is doing, and simply use a rule that says ‘do what everyone else does’. We call this the social proof heuristic. We use heuristics all the time because the world is too complex for us to judge every decision – we need a set of rules to live by so that our brain isn’t working overtime every minute.
In an experiment conducted in the 1960s Columbia University students were asked to take part in a study. Before being interviewed for the study, the students were asked to fill in some forms in the waiting room in one of the university buildings.
As they filled out the forms, smoke began to enter the room – enough smoke that in four minutes vision was impaired and breathing had started to be impacted. The students’ actions were being recorded under two different conditions.
In the first group, the students were alone in the room and during this condition they investigated the smoke more closely and then left the room to tell someone about it.
In the second group, the students were not alone – there were two or three people in the room who had been instructed to not react to the smoke but to shrug and continue to complete their form. In this condition only one of the ten subjects left the room to report the smoke. The others sat there, working on completing the form, whilst smoke filled the room and they started coughing and could not see.
It’s pretty mad to think that social pressure could be that strong.
Why am I telling you this?
Well, using short-cut rules (or heuristics) works for much of the time. They enable us to make quick decisions when we don’t have all the information. Like, for example, if someone throws a toy snake into your lap unexpectedly – you will react as if it is a real snake. However, rules of thumb can get us into trouble, especially when it comes to our money.
And unfortunately, this is never more true that when we find ourselves in a raging bull (up) market.
The US stock market has now almost doubled from the bottom in March 2020. Capital is plentiful, everything is getting funded and everyone is making money. And how wonderful it is!
However, the social proof heuristic (and a bunch of others) can mean that we are vulnerable.
Fraud is as old as the hills, but it’s particularly rampant when markets are flying.
Ben Carlson writes in his book ‘Don’t Fall For It; A Short History of Financial Scams’, “when things are going well, risk management goes out the window, people become more lax about their due diligence procedures and everyone becomes more trusting in money-making ventures.”
Here’s how it goes. You hear that Fred invested in X and you know Fred is a smart guy, he must have vetted it. You can rely on his assessment. Fred knew that Joanne invested in X and he knows that Joanne is a smart girl, she must have vetted it. He can rely on her assessment. And so on.
This environment is a fraudster’s dream because he (or she – think Elizabeth Holmes) doesn’t even have to try very hard. Making money is seductive – so seductive that the brain of someone looking to make money on their investments is indistinguishable from someone high on cocaine.
Throw some super cheap leverage into the mix and you have the potential for some fireworks.
I am here to tell you that no one is immune from this. If when reading this you thought you would never have stayed in the smoke filled room filling in a form, and you would never get caught up in a financial scam, then you are suffering from over-confidence, and that is the most dangerous bias of all.
Ben tells the story of Stephen Greenspan. Greenspan is an expert on human gullibility. He wrote an entire book on the subject (The Annals of Gullibility: Why we get duped and how to avoid it) which was released in December 2008, right in the middle of the financial crisis. It was right about the time that the biggest financial fraud of our time came crashing down – that of Bernie Madoff and his $65 billion Ponzi scheme.
A whole host of famous people who got caught up in the Madoff Ponzi – some of Hollywood’s most elite.
And guess who else? Yup, Mr Stephen Greenspan, the expert on human gullibility. The guy who wrote an entire book on how to avoid getting duped!
“One of the reasons fraud tends to spread like a virus is because it’s difficult to witness others earn what looks like easy profits.” Ben Carlson
So, knowing all this and accepting that none of us are immune, what can we do to protect ourselves?
Ben Carlson list six signs of financial fraud that you should be aware of:
The Money Manager has custody of your assets. Bernie Madoff had custody of his client assets – this enabled him to use client assets as his own personal piggy-bank. This is not the case for Liberty Wealth clients – all our client assets are held at a third-party institution. In fact, we never take custody of client assets. Clients control the transfer of funds into and out of their account. The decision-maker (Liberty Wealth) is separated from the custody. That should always be the case. If it’s not the case for your Money Manager, you are extremely vulnerable to fraud.
There is an aura of exclusivity in the pitch. I have seen this a few times recently and it’s a major red flag.
When the strategy is too complicated to understand. This works because (quoting Ben Carlson) “ a) we all like to believe we’re smart and don’t want to look stupid by admitting we don’t understand something and b) it’s much easier to be fooled by randomness when something is complicated or hard to understand.”
When the story is too good to be true. Guaranteed returns, no down-months – these are danger signs. Anything where someone promises you a return without a commensurate risk is probably something you want to say a big fat no to.
When the returns are ridiculously good. “Always remind yourself of the following – if someone could honestly produce consistently enormous returns every week, month, or year, why would they offer you the opportunity to profit with them in the first place? If they truly could earn such fantastic returns, they wouldn’t need to or want to tell anyone else about the secret sauce.”
When they tell you exactly what you want to hear. Fraudsters tend to be master story-tellers, and when we hear a good story we almost immediately let our guard down.
I am seeing investments at the moment that exhibit at least one of the above features. Be on your guard and remember that my job as your trusted guide is to stand between you and the big mistake. That, I promise, I will always do.
“The first principle is that you must not fool yourself — and you are the easiest person to fool.” Richard Feynman
Georgie
georgie@libertywealth.ky