Investor Psychology

The Lure of Ponzi Schemes

Educated investors are often too confident in their own capacity to evaluate a deal.

As swindles go, Ponzi schemes are about the most puzzling. Four years ago, a decades-long scam that bilked thousands of investors out of billions of dollars made Bernie Madoff a household name. Yet the schemes keep coming. Last year, the Securities and Exchange Commission shut down an online scheme that raised $600 million from one million Internet customers and a Utah-based real estate flimflam that allegedly defrauded 600 investors out of $100 million. A former college football coach was accused of victimizing other coaches and former players in an $80 million scheme, and a purported hedge-fund manager targeted the Persian–Jewish community in Los Angeles.

Such schemes have been around at least since 1920, when an Italian immigrant (and convicted felon) named Charles Ponzi persuaded New England investors to back a plan to buy postal coupons in one country and sell them in another. Ponzi’s razor-thin margins didn’t allow for the outsize returns he promised. Existing investors were paid instead with the money from new investors—the hallmark of a Ponzi scheme.

Hard to spot. Shouldn’t we know better by now? The unfortunate fact of human nature is that knowing better isn’t easy. Ponzi operations are typically light-years more sophisticated than the Nigerian money-transfer scams caught by your e-mail spam filter. As fraud expert and SEC trial counsel Pat Huddleston is fond of saying, “If it sounds too good to be true, you’re dealing with an amateur.” Madoff and his ilk don’t promise the moon; the returns they offer, albeit fictitious, are plausible.

For certain investors, Ponzi come-ons are like catnip. Risk-takers—not just in investing but in areas such as sports and hobbies—are vulnerable, says Tamar Frankel, a Boston University law professor and author of The Ponzi Scheme Puzzle: A History and Analysis of Con Artists and Victims. Victims often exhibit addictive personality traits, with the fear of loss outweighed by satisfaction in gains—or anticipation thereof. “You see it at the roulette table, and you see it in victims of Ponzi schemes,” says Frankel. Our need to belong explains why Ponzi schemes are so successful among affinity groups, and our craving for social status explains why, when Ponzi perpetrators try to turn would-be investors away, they fight all the harder to get in on the “exclusive” opportunity. Sophistication is no defense: Educated investors are often too confident in their own capacity to evaluate a deal.

Primed for trouble. Simply the way our brain processes information can lead to problems in the investing arena. Most of us have a general bias toward optimism. “Nobody thinks anything bad is going to happen. Otherwise, you’d never leave home in a world full of crime, germs and teenage drivers,” says Huddleston. A congruence bias prevents us from seeking evidence that conflicts with our impressions and leads us to discount such evidence if it’s presented.

So even if you set out to investigate an investment proposition, your unconscious goal may be to prove it legitimate. In other words, only if you look for a fraud do you have any hope of discovering one. The best way to sleuth is to look for evidence of previous fraud. For pennies a page you can scour court records. For $9.95, double-check education credentials (and be unforgiving of truth-stretching) at www.studentclearinghouse.org. Investigate a broker at Finra.org, or get a background check from your state securities regulator. Look up investment advisers. And keep your money in a custodian account at a reputable brokerage instead of handing it over to an adviser. Statements from the custodian will detail activity in the account, making it easy to spot phony statements from a scam artist.

Anne Kates Smith is a senior editor of Kiplinger’s Personal Finance magazine.

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