Keeping Vigilant for Investment Fraud

At the SEC we used to say that if we found more than two doctors invested in any unregistered security, it was probably a fraud. Doctors are targeted that often.

They have a high level of investable income and little time to pay attention to investments. Plus, they chat. In the operating room or in the doctor’s lounge, one doctor says what a terrific return he’s been getting through a limited partnership or a hedge fund. Another laments that his investment returns have lagged the market for more than a year. “You should talk to my guy,” says the first.

And that’s how an epidemic that will cost doctors the equivalent of several years of income spreads.

Why do so many doctors lose so much to investment fraud?

The answer lies in a realm with which doctors are familiar. As healthy as we may otherwise be, all humans have compromised immune systems when it comes to recognizing investment fraud. We aren’t born with the antibodies to fight it.

The deficiency is congenital and centered between our ears. All healthy brains come prewired with what psychologists call “cognitive biases.” Those biases are useful in most instances, but absolutely deadly in the investment context. Traditional due diligence methods have ignored them to the detriment of millions.

“Risk perception research in healthy adults shows that . . . they frequently exhibit a bias known as ‘unrealistic optimism’ in which individuals feel they are less likely than other people to experience unpleasant or harmful events in their lives but more likely to experience pleasant or beneficial events.”

Put another way: people rarely believe that the disaster scenario — including the disaster of financial fraud — can happen to them. And if disaster isn’t a possibility, they take no steps to guard against it.

A second bias, the congruence bias, is especially insidious because it infects those who don’t take things at face value. The congruence bias leads us to hold firmly to our first theory to explain any given situation.

Our first theory upon hearing about an attractive investment from a charismatic financial adviser — vouched for by a respected colleague — is that the adviser is who he or she appears to be and that the investment is legitimate. Under the effects of that bias investors who insist on confirming the essential facts for themselves believe that they are doing adequate — even extraordinary — due diligence, while, in fact, the congruence bias is actually setting the scam artist’s hook deeper.

Doctors today have technological tools at their disposal to help accurately diagnose their patients. Still, because of the cognitive biases, doctors fail to use diagnostic tools on investment opportunities.

Of course, being able to order the correct tests requires that we first treat the above-mentioned cognitive biases. We can ameliorate the optimism bias by rejecting the blame-the-victim instinct and accepting our vulnerability. And we can defeat the congruence bias by intentionally pursuing the theory that the investment is a fraud, rather than seeking to confirm legitimacy.

Investment literature is full of the warning, “Past performance is no guarantee of future results.” That is true. But it is also true that, with human beings, the best predictor of future behavior is past behavior. A vigilant investor therefore looks into the past of the people behind the investment.

One of the most powerful tools is Pacer, which provides access to the docket of every federal court in the U.S., coast to coast. Civil cases. Criminal cases. Bankruptcy cases. They are all in Pacer. Most state court systems have no counterpart, but you can search state court dockets at the courthouse. Avoiding a substantial loss is worth the legwork required. Remember to search not just on the name of the individual but also on the name of any companies he or she has controlled.

Lexis-Nexis is another useful diagnostic tool. It can tell you whether an investment promoter is operating under an assumed name, fleeing a past full of the kinds of trouble that a Pacer search on his or her real name would have revealed. Lexis-Nexis will also reveal civil judgments and tax liens, indicating a person with a powerful financial incentive to cheat current investors.

The palpation of investment diagnostic tools is shoe leather investigation. Observe the lifestyle of the people behind the investment. Extravagant spending is the first item on the Ponzi scamster profile. Also, pay a visit to the supposed auditors or attorneys involved with the investment. Oftentimes you’ll find a sham operation no more real than the buildings on a Hollywood sound stage.

A consultation with your local securities regulator is always a good idea. If the person trying to sell you an investment or give you investment advice is not properly licensed to do so, stay away. While proper registration is no indicator of legitimacy, selling investments without a license is a sure sign of an ongoing fraud.

As helpful as these diagnostic tools are, the results will always find their way to a human who must interpret the findings and make a sound judgment. Diagnostic skill has everything to do with experience. The more patients a clinician sees, the better able he or she is to arrive at an accurate diagnosis sooner. The same is true of those of us who look for fraud rather than disease.

Sir Arthur Conan Doyle could have been speaking to aspiring doctors when he explained the secret of Sherlock Holmes’s powers of detection.

A Study in Scarlet

“There is a strong family resemblance about misdeeds,” he wrote in . “And if you have the details of a thousand at your finger ends, it is odd if you cannot unravel the thousand and first.”

The experienced clinician has seen hundreds, if not thousands, of patients. His long experience gives him confidence in his diagnoses. He probably remembers diagnoses he made during his medical residency — when he was just as confident, but more often wrong — with a tinge of embarrassment and laughs at his inexperienced self.

No doctor will see as many investment opportunities as he will see patients. A doctor awakened to his cognitive biases and the wisdom that comes with experience will think of himself as a resident in the school of investments.

Just as he would seek a consultation with a specialist to aid in the diagnosis of a patient, the wise doctor will seek the wisdom of those who have seen hundreds of cleverly disguised frauds and know how to recognize subtle red flags. He will read books and blogs about breaking scams to pick up knowledge about how such scams operate, to be better able to recognize the predators who aim to rob him and his patients of a lifetime of savings.

And the next time a colleague brags about his investment returns in the doctors’ lounge, the wise doctor will hear those words with a new level of understanding.

The Vigilant Investor: A Former SEC Enforcer Reveals How to Fraud-Proof Your Investments

The Optimism BiasA 2005 study^[i] concluded:The Congruence BiasDiagnostic testsConsultationPat Huddleston is the author of (AMACOM, October 2011). He is a former Enforcement Branch Chief at the U.S. Securities and Exchange Commission and the chief executive officer of Investor’s Watchdog, LLC, a fraud prevention due diligence company. www.investorswatchdog.com

Optimistic Bias in the Perception of Personal Risk: Patterns in Schizophrenia

^[i] Kristen J. Prentice, Ph.D., James M. Gold, Ph.D., and William T. Carpenter Jr., M.D. , American Journal of Psychiatry (March 2005).