The sucker syndrome at the heart of frauds

After covering federal court over the years, I've learned one thing for sure: When it comes to investing, there's a sucker on every corner. And if you think you're not one of them, you're the biggest sucker of them all.

My hard drive is filling up with what I call "investment scam cases." Some of them are classic Ponzi schemes (think Bernie Madoff). Others, variations on a theme, often built off mortgage fraud or day trading or some pyramid-marketing ploy.

Why do people keep falling for these pitches year after year? These investors should get a brain!

As it turns out, their brains may be at the root of the problem. Recent research shows we're hard-wired to fall prey to investment frauds. Gullibility, it seems, resides in the limbic system, comprising several structures that sit atop the brain stem and serve as the gateway to the cerebral cortex, where higher reasoning occurs.

Or, in the case of gamblers and Ponzi scheme victims, where higher reasoning fails.

In January 2008 I wrote about a federal investigation of a Minneapolis woman named Kalin Dao, who allegedly bilked about $10 million from investors on the promise of high returns. Some of her investors called to object. Several defended Dao and wanted the government to stop meddling in her business. U.S Postal Inspector Robert Strande, one of the lead investigators, said he was having a hard time getting the investors to contact him with evidence. Some investors said they even loaned Dao money months after learning about the investigation, hoping she would use it to make things right.

Are these people crazy?

Peterson cofounded MarketPsych, a consulting firm, and is managing director of MarketPsy Capital, a small hedge fund. Studies show that the larger the potential reward, the more people diminish their perception of risk, he said.

"Everyone has this gullibility, and once they get involved, they turn off their ability to see it as risk," Peterson said.

'Neuroeconomics'

The prefrontal cortex helps us think ahead and make strategic plans, he explained. "The problem is strong emotional feelings or motivations. When you really want something to be true, your limbic system is so active it will turn off and override ... any of the input from your prefrontal cortex. In fact, it will use the prefrontal cortex to create a story as to why to believe that things are OK, which is part of, you know, how all of Wall Street ended up in this mess," Peterson said.

The study of such behavior is part of a developing field known as neuroeconomics, a combination of economics, psychology and neurology, according to journalist Jason Zweig, author of "Your Money and Your Brain."

Peter Bossaerts, a professor with the Computational and Neural Systems Program at the California Institute of Technology, agreed. "If you feel you're on the cusp of disaster, you will tend to want to take more risk," Bossaerts said in an interview with Money & Minds, a blog on neurofinance.

So one thing investment advisers can do is tell clients beforehand to expect emotional turbulence, and then help them to ignore it. Solid research and experience on this phenomenon comes from the field of aviation.

"Pilots are trained very often to ignore their own cognitive input when they're flying through the clouds," Bossaerts explained. "When flying through clouds they feel the airplane is banking." But pilots are trained to ignore those feelings, and instead rely on their instruments.

Similarly, bankers and investors need good financial measures to help guide their decisions, Bossaert said.

Society can't afford to take a buyer-beware attitude when it comes to financial scams. According to MarketPsych's Peterson, when that happens, "you have this social contagion effect."

Tapping the power of social networks is the Holy Grail for marketers and con artists alike. Madoff perpetrated a $50 billion Ponzi scheme that way, convincing new investors that they needed recommendations from current investors to join his elite club. Closer to home, Kalin Dao -- now facing federal conspiracy, fraud and money laundering charges -- allegedly used a similar ploy, capping membership in her various investment solicitations. Securities regulators warn against such "affinity frauds."

John Stevenson, owner of J&G Window Wash in Las Vegas, says he invested more than $80,000 with Dao after watching his friends collect dividends on their investments. He then spread the word, hoping to share the wealth.

Asked why he trusted Dao, Stevenson said: "We've had people with millions of dollars [who tried] to invest with them and they told them, flat out, 'No.' I mean, they said, 'No, we already have enough money,'"

Now that's crazy.