Financial con artists will stay with us as long as we wish to make money. There are few areas where scepticism is more important than how one invests one's life savings. Yet intelligent and educated people, some of them naïve about finance and others quite knowledgeable, have been ruined by schemes that turned out to be highly dubious and quite often fraudulent. The most dramatic example of this in Sri Lankan history came in the form of Golden Key and a dodgy scheme run by a chap called Sakvithi.
The scam pulled by them and other similar individuals had a pretty simple recipe; promise unbelievably high guaranteed returns, exclusivity and secrecy from everyone, including the tax authority. Robert Cialdini, a psychology professor at Arizona State University and author of "Influence: Science and Practice," calls this strategy "a triple-threat combination."
The murkiness and non disclosure of investment strategies, makes investors feel that it is "the inherent domain of people who know more than we do." This uncertainty leads us to look for social proof: evidence that other people we trust have already decided to invest. And by playing up how exclusive these investments were, these players shifted investors' fears from the risk that they may lose money to the risk they might lose out on making money.
If you did get invited in, then you were anointed a member of this particular club of "special investors." Once someone you respect went out of his way to introduce and grant you access, it would seem almost an "insult" to do any further investigation.
This members-only feeling blinded many investors in to not asking simple questions like, “how can you make me more money than a bank deposit?” Worse, it prevented many from doing any due diligence (asking basic questions of past history and character) about any of the individuals who were going to be in charge of all their life savings.
The basic mechanism explaining the success of such Ponzi schemes (where the schemer pockets all the money and investors who wish to redeem their money are actually paid out of proceeds from new investors) is the tendency of humans to model their actions - especially when dealing with matters they don't fully understand - on the behaviour of other humans. This mechanism has been termed "irrational exuberance," a phrase coined by economist and professor at Yale, Robert J. Shiller.
Prof. Shiller employs a social psychological explanation that he terms the "feedback loop theory of investor bubbles." Simply stated, the fact that so many people seem to be making big profits on the investment, and telling others about their good fortune, makes the investment seem safe and too good to pass up. This applies to both scams and genuine investments alike.
While social feedback loops are an obvious contributor to understanding the success of Ponzi and other mass financial manias, one also needs to look at factors located in the dupes themselves. Professor Stephen Greenspan is an expert on human gullibility and authored the highly readable "Annals of Gullibility." According to him, there are four factors which can be used to understand acts of gullibility, but also other forms of what he terms "foolish action."
The four factors are situation, cognition, personality and emotion. Every gullible act occurs when an individual is presented with a social challenge that he has to solve. In the case of a financial decision, the challenge is typically whether to agree to an investment decision that is being presented to you as benign but may pose severe risks. Deficiencies in knowledge and/or clear thinking often are implicated in a gullible act. Anyone can have a high IQ and still prove gullible, in any situation. Gullibility is sometimes equated with trust, but research shows that not all highly trusting people are gullible.
Trust and niceness accompanied by an occasional tendency toward risk-taking and impulsive decision-making personality traits makes for a deadly combination. Emotions enter into virtually every gullible act. In the case of investment in a Ponzi scheme, the emotion that motivates gullible behaviour is excitement at the prospect of increasing and protecting one's wealth.
Golden Key won’t be the last scam to outrage investors, as plenty of con artists will play on human emotions in the future. While governments can tighten policies, and increase oversight, schemers will always find loopholes to attract enough gullible people. If you invest with anyone who claims never to lose money, will not explain their strategy, refuses to disclose basic information or discuss potential risks, you're not special. You're being foolish.
Its hard not to be gullible, just ask Prof Greenspan. Months after writing the book, he would go on to lose over 30 % of his retirement savings invested with Bernard Madoff, the largest schemer of them all.
(Kajanga is an Investment Specialist based in Sydney, Australia. You can write to him at email@example.com)