The Psychology of Investing Scams

5 techniques fraudsters use to draw investors into Ponzis, pyramid schemes, and other scams.

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Although the housing bust, credit crisis, and market swoon undoubtedly take center stage these days, another drama is playing out on Wall Street: high-profile investment fraud. The tally of money managers recently accused of bilking investors out of billions of dollars is growing: Bernard Madoff and his alleged Ponzi scheme; R. Allen Stanford, accused of swindling investors with high-yielding certificates of deposit; and a handful of others arrested in fraud probes. Investing con artists certainly aren't new on the scene, but many have been flying under the radar for years, says Jeff Layman, chief investment officer of BKD Wealth Advisors, based in Springfield, Mo. "These scams are contingent on getting a continuous inflow of investor dollars," he says. "But when those dollars stop coming in and investors are looking to withdraw, things implode." So what makes investors fall for scams in the first place? Psychological persuasion techniques are the key, says John Gannon, senior vice president for investor education at the Financial Industry Regulatory Authority. Using actual transcripts of fraudsters in action, FINRA put together a list of five common scam tactics:

The "Phantom Riches" Tactic. This is the classic too-good-to-be-true pitch. Think lofty interest rates on traditionally conservative CDs—as in the Standford case—or guaranteed double-digit returns à la Madoff. "Look around in this market—there are very few places where you can get that kind of return on your money," says Gannon. These days, scammers prey on investors who are disillusioned by the so-called "Lost Decade" for stocks, which points to data showing that the stock market is trading below what it was ten years ago. "They send the message that wealth accumulation has been unrewarding over the past 10 to 12 years," says Layman, who adds that baby boomers are often targeted in this scheme. "You've got people on the doorstep of retirement who need big returns but don't need risk, so when someone says they can generate 8 percent to 10 percent returns, that's obviously very appealing." The bottom line: If someone promises an investment return that is unnaturally high or steady, the warning alarm should start sounding.

[See Stanford Blow-up: What Will Happen to Investors' Money]

The "Source Credibility" Tactic: A scary truth is that anyone can call himself or herself a financial planner or adviser, so it pays to check with national organizations that issue credentials (they include the National Association of Personal Financial Advisers, the Financial Planning Association, and the Certified Financial Board of Standards.) "It's easy to fake a diploma on the wall...people see alphabet soup after someone's name, and they automatically think it means expertise," says Gannon. "And remember, anyone can put on a suit." After you make sure that the person you're dealing with is accredited, you should also make sure product he or she is selling is registered with the SEC. Hedge funds are an example of an investment that's not registered, Gannon says: "In the Madoff situation, people truly had no idea what he was doing with their money—there was the fuzzy idea that he had an algorithm to make profits, but no one had a good understanding how he was going about making money." If you don't understand how the investment generates returns, think twice.

The "Social Consensus" Tactic: Scam artists may employ a sort of peer pressure by claiming that other investors have already invested, such as those in your social circle or perhaps your church. "Madoff had people in country clubs in Florida investing," says Gannon. Dean Barber, president of Barber Financial Group in Lenexa, Kan., says fraudsters sometimes use the allure of exclusivity: In the Madoff case, people believed because this guy had been around a long time and had some big clients." When investment frauds occur, it's often when a client signs on with a manager (financial adviser) who's also the the custodian of the account. A custodian, which would include the Fidelitys and Charles Schwabs of the world, is in possession of your investment account and issues periodic statements of transactions. The manager of assets executes those transactions. It's a good idea to keep managers and custodians separate, which ensures that all power won't fall into one person's hands.