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Why We Don’t See the Fraud in Front of Our Faces

posted Apr 27, 2012, 1:51 AM by Resty Manapat

Why do smart people fall for huge fraud schemes? Optimism bias rears its happy head.

You may have heard of Wayne McLeod. He was a successful investment advisor in Jacksonville, Florida, who invested $43 million from 1,100 investors in his “special bond” fund that didn’t exist. The irony of the massive financial fraud perpetrated by a man Businessweek called a “mini-Madoff” is that the clients of his fraud scheme were primarily law enforcement officers.

McLeod had found a niche for himself, giving investment advice to Federal law enforcement employees, and then investing the profits from the sale of their homes through his fund. He did this for more than 10 years and was so popular that agencies paid him up to $15,000 per session to talk to employees about investing their retirement income.

When questioned by a newspaper reporter after the story broke, an FBI special agent who had lost money in the scheme said: “I am at a loss to explain myself”. We are professionally suspicious people. When we see a clown we think child molester. So how could we be taken in by this?”

The Guy Who Wrote the Book

That’s a great question, says Pat Huddleston, a professional speaker, author and CEO of Investor’s Watchdog LLC, a due diligence company that conducts investor fraud prevention investigations. It’s not because of low intelligence and it’s not because of gullibility, said Huddleston in a session at the ECOA conference in September.

He gave the example of Stephen Greenspan, a well-respected psychologist and author of the book The Annals of Gullibility, who lost $400,000 to Madoff. “So the author of this book on gullibility fell for the biggest investment scam ever,” said Huddleston.

In an interview afterwards with Morley Safer of 60 Minutes, Greenspan said that our defenses against conmen are compromised by anxiety, by that awful feeling that we are losing out, that others, friends, family are getting fabulously rich while we are just getting by. “In other words, it is the anxiety of envy and greed that drives us into the welcoming arms of Madoff, et al,” said Safer.

Huddleston has another explanation. “It’s humans being humans,” he said. “Humans walk around with certain cognitive biases, certain ways of thinking that help us in most areas of life, but absolutely hurt us in the investment context.”

Optimism Bias

“There’s a base level of optimism that we all have that gets us out of the house in the morning,” said Huddleston. “And it is this: that we don’t believe that anything particularly disastrous is going to happen to us. Disasters happen to other people.”

He talked about the way the human brain seeks to avoid vulnerability by putting its host into a different category from the people who fall for scams, characterized by thoughts such as: “Who would fall for that? I would never fall for that.”

He used the example of a toddler falling off a balcony and the way the story is perceived by others who think that “those things only happen to people who are negligent parents. I’m not a negligent parent so that would never happen to me.”

So when you meet with a financial advisor, the disaster scenario simple doesn’t come into play, says Huddleston, because of the optimism bias.

“Cognitive biases are like optical illusions in that the effect remains even though you know you know it’s an optical illusion,” says the FBI manual.

“The knowledge of it is not, by itself, enough to remove the effect,” said Huddleston. “But knowing about is job number one.”

SOURCE: i-Sight