Financial advisors want to be heroes to their clients. Fantastic performance creates fantastic word of mouth, which leads to more clients and more assets under management. Scam artists know that you want to be a hero to your clients. That's why savvy fraudsters will always seek the endorsement of honest, ethical financial advisors. You hold the key to the vault that holds your clients' assets. If the scamster can convince you that his or her investment is legitimate, safe, and profitable, you will unlock that vault, hoping that the returns on this investment will help make you a hero to your clients. Many months or many years later, the scam artist will flee or go to prison, leaving you guarding an empty vault, answering difficult questions from angry clients.
I speak to financial advisors all over the country about fraud prevention and effective due diligence techniques. So I know what most of you are thinking right about now: “People who fall for investment scams are greedy, gullible, and/or stupid. I'm none of those things.” We all tend to think that. But it is that thought, more than any other, that leads American investors to lose more than $40 billion — two Madoff mega-frauds — annually to investment fraud.
In more than two decades of protecting investors, both at the SEC and out, I've met investors of all shapes and sizes: public pension funds, university endowments, family offices, wealthy professionals, and blue collar retirees. What ties them all together across a vast economic range is that, before they lost their assets to a fraud, they all believed that they were too smart, sophisticated, or sensible to fall for a fraud. It is the mindset that every scam artist hopes you will have. It makes taking your assets so much easier.
Psychologists tell us that our tendency to blame the victim and our unwillingness to believe that we could fall victim to a similar disaster are evidence of powerful mental processes that happen behind the scenes of our conscious thought. We don't like to feel vulnerable, and our brains work to differentiate us from the victims of a scam. And, of course, if we don't believe we are vulnerable, we don't take any precautions.
Protecting yourself and your clients from fraud, therefore, requires first and foremost, admitting vulnerability. Once across that vulnerability threshold, you find vast resources that can protect you not only from fraud, but also from recklessness and ineptitude that don't rise to the legal definition of fraud but are just as deadly to your financial goals.
Step two in becoming the hero who saves your clients' assets requires learning about how fraud operates and how to track it down. Trust me on this: The axiom, “If it sounds too good to be true, it probably is,” is worthless as a defense against most scams. At Investor's Watchdog we say, “If it sounds too good to be true, you are talking to an amateur scam artist.” Only rookies and the not-very-bright promise outlandish returns. Advisors who want to be heroes, therefore, have to know much more than trite axioms.
The proper education begins with understanding what psychologists call “cognitive biases.” You can think of them as the default operating system of every healthy human brain. Cognitive biases help us navigate a complicated world. Behind the scenes of our conscious thought they simplify problems down to manageable size. They help us in most aspects of daily life, but they hurt us in the investing context.
The Central Intelligence Agency trains its intelligence officers on the impact of cognitive biases. The CIA's Center for the Study of Intelligence writes:
“Cognitive biases are mental errors caused by our simplified information processing strategies. … [They] are similar to optical illusions in that the error remains compelling even when one is fully aware of its nature. Awareness of the bias, by itself, does not produce a more accurate perception. Cognitive biases, therefore, are, exceedingly difficult to overcome.”
The reference to optical illusions is accurate. A competent investment scamster will use the cognitive biases to make you see things that aren't there and ignore things that you ought to pay attention to.
Due diligence is supposed to frustrate fraud, to expose it. But traditional methods have proven astoundingly ineffective. Public pension funds, Fortune 500 companies, university endowments, family offices, and the retirement accounts of investors of every size continue to lose money to cleverly disguised frauds. Industry standard due diligence has been — and will continue to be — a failure because it has not yet taken notice of cognitive biases and other behind-the-scenes mental processes that play such a powerful role in our investment decisions.
Albert Einstein said, “Insanity is doing the same thing over and over and expecting a different result.” Unless advisors learn a better due diligence approach, they and their clients will continue to suffer. With investors of all sizes still reeling from the losses of 2009, investors need a hero like never before. Only advisors who admit vulnerability and learn more about what's going on behind the curtain of our conscious thought will be equipped to be heroes to their clients.
Pat Huddleston, the author of The Vigilant Investor, is a former SEC Enforcement Branch Chief, and the CEO of a due diligence company, Investor's Watchdog.