How to Dodge Investment Scams

The most persistent myth about investment scams is that only stupid people fall victim. Stupidity is a factor, of course, as long as you define it as a failure to do enough research about a product or service. More commonly, however, investors lose money because they followed their emotions -- and that can happen to anyone, regardless of education, experience, age, or income.

As New York consumer advocate Asa Aarons explains:

Who's likely to become a victim? The young. The old. And everyone in between. People with little or no money, and people with more money than they need. Anyone... even you.

Con artists effectively tap a dizzying array of emotions. Greed and vanity are at the top of the list. It's hard to resist an offer of double-digit returns (just think what we'd do with that money!). It's just as hard to resist the message that we're special: We're getting in on a super-secret, once-in-a-lifetime opportunity -- something so wonderful we shouldn't share it with anyone, not even our bankers, lawyers, or accountants.

The secondary drivers include envy, panic, denial, exuberance, trust, and naiveté. We want what someone else already seems to have, and panic at the prospect of missing the deal. Or maybe we just get so excited by an offer that we toss aside reason and coast on our exuberance. Some people are just too trusting. Others don't want to appear impolite by questioning something other people seem to think is a good deal.

Many just refuse to see the obvious, including signs of fraud -- especially if they've been "making money" from an investment. That's often the case with pyramid or Ponzi schemes. People who get in on these deals early enough may see a profit, but it's not from a successful investment. It’s just using the cash from new recruits to pay the old ones. It works, until the scheme grows too big. Once it does, the promoter is unable to raise enough money from new investors to pay the current ones.

The pyramid collapses, and many people lose their money. The Financial Industry Regulatory Authority (FINRA), the largest independent regulator for all securities firms in the US, analyzed 600 hours of undercover audio tape to get a better understanding of the psychology of scams.

The tapes revealed that fraudsters are masters of persuasion, tailoring their pitches to match the psychological profiles of their targets. They look for an Achilles heel by asking seemingly benign questions -- about your health, family, political views, hobbies, or prior employers. Once they know which buttons to push, they'll bombard you with a flurry of influence tactics, which can leave even the savviest person in a haze.

Some of the most common tactics include:

• Phantom riches: Dangling the prospect of wealth, or enticing you with something you want but can't have. "These gas wells are guaranteed to produce $6,800 a month in income."
• Source credibility: Building credibility by claiming to be with a reputable firm or by having special credentials or experience. "Believe me, as a senior vice president of XYZ Firm, I would never sell an investment that doesn't produce."
• Social consensus: Leading you to believe that other well informed investors have already jumped in. "This is how (fill in the blank) got his start. I know it's a lot of money, but I'm in, and so are my mom and half her church, and it's worth every dime."
• Reciprocity: Offering to do a small favor for you in return for your investment. "I'll give you a break on my commission if you buy now."
• Scarcity: Creating a false sense of urgency by claiming limited supply. "There are only two units left, so I'd sign today if I were you."

It's tempting to think you can profit from an investment offer, and it's flattering to think you're one of a few being offered the chance to invest. But it's a mistake to act quickly, take claims at face value, or ignore your own questions about the legitimacy of a deal.