Fraud

Fraudsters Leverage Psychological Biases to Steal Your Money

by Evan Stroman | April 2019
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Denial. Anger. Depression. There is no typical response to financial loss due to fraud, but this article may help you understand why you selected a particular investment or even allow you to spot a scheme before it’s too late.

Let’s suppose that a few years ago, your friend or your broker convinced you to put your money into a can’t miss investment—a well performing, actively managed fund with a unique strategy. Perhaps that strategy involved selling high-yield promissory notes tied to a lucrative real estate deal, or maybe you were offered the chance to buy into an IPO before the company went public.

Months passed. Years. But the returns never materialized. Instead, you were bombarded with a litany of excuses: “the real estate market is too tight, just wait until the property sells.” Or you were told, “we’re going to extend your note for another year, but don’t worry, we’ll compound the interest we owe you into a balloon payment on the back end.”

And so you held on and hoped for the best. After all, this investment was recommended by your neighbor, or that advisor you’ve worked with for nearly a decade. You convince yourself that your funds are safe. That is, until the headlines splash across your screen: “Ponzi!”; “Scheme!”; “Fraud!” And the stories are talking about your money.

How did it go so wrong, and how did you get duped in the first place?

Prospect Theory describes the way people choose between alternatives that involve risk when the likelihood of each outcome is uncertain, such as when you make an investment decision. As theorized by Daniel Khaneman and Amos Tversky, when faced with a situation where we cannot calculate the odds of success, our judgment making ability is impaired by certain inherent biases, called “heuristics.” The reason we create these heuristics, according to Khaneman, is that “we can’t live in a state of perpetual doubt, so we make up the best story possible and live as if the story were true.”

The “Representativeness” heuristic is the use of categories when making decisions. Here’s an example. Perhaps you met your fraudster in the flesh. You didn’t know whether she was going to steal your money, but you decided, based on certain attributes, that she did not appear to be a criminal. Did she wear a nice suit? Smile? Answer all of your questions effortlessly and eloquently? Representativeness explains that “the confidence people have in their beliefs is not a measure of the quality of evidence, but of the coherence of the story the mind has managed to construct.” At the time of your investment, you decided that she looked and spoke like someone you could trust.

The “Anchoring” heuristic explains why fraudsters often promise guaranteed returns to get you to buy into their scheme. Anchoring is when our decisions are tied to a provided number, rather than our own understanding of the outcome’s probability. What are the chances that purchasing debt tied to a real estate deal will pay 10% interest every single year? I honestly have no idea, but a guaranteed 10% return is enticing. As described by Khaneman, “a reliable way to make people believe on falsehoods is frequent repetition, because familiarity is not easily distinguished from truth.”

Lastly, “Availability” bias is the ease with which a particular idea can be brought to mind. You saw a prospectus—it had renderings of the final product, financial statements, and a clear road map for success. So even when the company couldn’t make its payments on time, you rationalized that cash flow issues were predictable based on the prospectus. This is because of availability bias: “once you have accepted a theory and used it as a tool in your thinking, it is extraordinarily difficult to notice its flaws.” Further, “if you come upon an observation that does not seem to fit the model, you assume that there must be a perfectly good explanation that you are somehow missing.”

Fraudsters exploit heuristics from the point of investment through the time that their scheme collapses. They use Representativeness and Anchoring to lure your money into their fund, and then perpetuate their fraud through Availability. Understanding Prospect Theory may help you to avoid fraudulent investments altogether, or to spot a scheme before a fraudster has expended all of the scheme’s assets.

Evan Stroman
Evan focuses on complex litigation and has represented defrauded individual and institutional clients who were lured into Ponzi schemes, lost millions of dollars due to a fiduciary’s wrongful conduct, or who were fraudulently induced to enter into deceptive contracts with foreign manufacturers. As a CPA and former auditor, Evan is experienced in recognizing the improper flow of cash through an organization and pinpointing fraudulent activity.
estroman@kttlaw.com

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