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Fighting Investment Fraud: The One Thing that You Need to Know

The US Senate Special Committee on Aging in 2006 held hearings on "How Seniors can stop Investment Fraud".

Barry Minkow, the man behind the ZZZZ Best fraud in 1980's but now running the Fraud Discovery Institute had a very interesting submission, in which he defined fraud as "the skin of truth, stuffed with a lie".

Terrific and memorable description of fraud!

There are three things that all fraudsters fear, because it leads to loss of control: a) reporters who do investigative journalism and report on ongoing frauds;

b) critical thinking by investors, and;

c) accountability.

Several years ago, I used to give a special lecture in Professor Paul Thagard's Critical Thinking class on Fraud and Logic, so I want to focus on what Minkow says about critical thinking.

Mr. Minkow identifies three factors an individual could use in making an investment decision, which makes the individual a target.

First, the individual relies upon the testimony or authority of a close friend or relative, who appears to making a substantial amount of money.

Second, the individual cannot know very much about actual market conditions or have access to detailed information about the market.

Third, there must be "blind and unsubstantiated" acceptance that the returns are significantly higher than the "current, underachieving returns" of the victim.

And I, suggest, that these "underachieving returns" can be turn into "significantly higher returns" with no risk.

However, an important study NASD Fraud Study 2006 appears to challenge my assumption that victims are bad at risk reward trade-offs, which would be a form of investor ignorance.

The entire study is very interesting, but one piece of information stands out:

"When it came to investigating differences between victims and non-victims of investment fraud, a major hypothesis was that victims of fraud knew less about concepts related to investing than non-victims and consequently would score significantly lower on financial literacy questions than non-victims.

The most surprising finding of the entire study was that just the opposite was true: victims outscored non-victims by a statistically significant margin.

Investment fraud victims answered 57.75% of the eight questions correctly compared to the non-victims who answered 41.00% of the questions correctly.

Lottery fraud victims scored the lowest on the financial literacy questions at 31.53%."

This is quite amazing, but a review of the answers shows something else.

There was one question that all the victims did poorly on:

Question 62. When an investor diversifies his or her investment, does the risk of losing money decrease, increase or stay the same?

The correct answer is risk decreases, and therefore so does reward.

But the fraud victims got this wrong.

Why would fraud victims, who generally knew more than the non victims, make this mistake?

Is it a clue to why they were defrauded, being as ignorant of the economic risk/reward ratio as the average non investor?

John Nofsinger may well have a partial answer, writing at Psychology Today, he states:

"While this [economic] theory of risk and return describes the investment choices quite well, it does not describe how people think about those choices.

Indeed, people tend to believe the opposite, that risk and expected return are negatively correlated.

They believe that the stocks they like will earn high expected return with low risk!"

What this suggests is that, victims of fraud are no better off than the average non-investor in not seeing that high rewards signals high risk. Given all of the other factors, Minkow points to it is not surprising that the high financial literacy of victims doesn't protect them against fraud - the one thing that they needed to know, they got wrong.

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Full post as published by Misleading Advertising Law on July 01, 2008 (boomark / email).