Scam artists aren't so much artists as they are students of human nature. If you consider that the rich and sophisticated (think Bernie Madoff's victims) are just as likely to be taken as anyone else, there must be some common denominator that makes us all vulnerable. And it's not just gullibility. To sucker us into scams, crooks manipulate the same psychological biases that often harm our investing decisions.
The hook is baited as soon as we meet a well-dressed, articulate pitchman. Our first reaction is that this guy must be legit and his offer worthwhile. What we don't realize is that this impression imbeds itself surprisingly deep in our gray matter.
Pat Huddleston, a former Securities and Exchange Commission enforcement officer who now heads Investor's Watchdog, says that "we're subconsciously and stubbornly tied to that first theory," and we tend to assemble facts to support it. "We think that everything really is what it appears to be, and when we get a fact that doesn't quite fit in the puzzle, we force it in," says Huddleston, whose firm is hired by pension funds, endowments and individual investors to sniff out fraud.
Here's the thing: Scam artists know we have this "confirmation bias," and they're happy to provide corroborating evidence to nudge it along. Take the case of Marc Dreier, who is currently serving a 20-year sentence for securities fraud. Dreier's case involved merely hundreds of millions of dollars, versus the billions that Madoff bilked from investors, and the scandal broke shortly before Madoff's. Dreier arranged for an associate to pretend to be either an independent accountant or the CEO of another company to confirm, via phone calls, that Dreier's offer could be trusted.
Huddleston says that "any scam artist worth the title can arrange some level of confirmation for you." The trick, he says, is not to seek confirmation but to be on the lookout for fraud.
Another powerful bias that makes our getting hoodwinked more likely is the "optimism bias." This is our tendency to overestimate the likelihood that good things will happen to us and underestimate the potential for unpleasant events. Crooks play to this tendency by making good things happen -- at first. That's why they have victims take small steps with positive results -- say, an initial investment that pays off -- to lull investors into a false sense of being in control.
A study of scam victims by the U.K.'s University of Exeter confirmed this illusion of control. Victims "believed themselves to be protected against fraud by the law and government to an extent that was in fact unrealistic or simply impossible," the study said.
Surprisingly, the illusion of control is heightened if the victim already has some expertise in the subject of the scam, the study found. So people who play lotteries or sweepstakes are more likely to fall for a lottery or sweepstakes swindle, and those with some experience in investing may fall for investment fraud.
But the most surprising finding may be that victims tend to put more effort into investigating a scam than non-victims. It's possible that this is a result of the same bias that's the bane of so many investors: overconfidence. We think we know more than we actually do, often basing our conviction on the inflated importance of relatively little knowledge. So victims who may be suspicious but are also overconfident gather some evidence and are then satisfied enough to feel secure.
Crooks are plugged in to this, says Huddleston. "The person who's convinced he's too smart to fall for a scam is putty in their hands," he says. His best advice: Admit that you're vulnerable when someone approaches you with a deal that sounds too good to be true, and either trust your first instinct and walk away or suspect that you're being conned and investigate accordingly.