Although stories of financial fraud run rampant have dominated headlines during the recession, a recent survey shows that not much has changed when it comes to the percentage of both Canadians who say they have been approached with a possible fraudulent investment at some point in their lives and of those who say they have committed money to such frauds.
What has changed is that fraud attempts are shifting toward more personal approaches and away from random, anonymous emails.
“The nature of the fraud attempts is changing,” says Karen Manarin, deputy director of enforcement with the Ontario Securities Com-mission. “Trust is key, and this is reinforced by the fact that 20% are introduced to the fraudulent activity by a friend, neighbour, co-worker or family member.”
Approximately 40% of people who responded to a Canadian Securities Administrators survey conducted by pollster Ipsos-Reid Corp. this past summer report that they have been approached with a possible investment scam, while 11% say they have invested money in such schemes. These numbers are little changed from the first edition of the survey in 2006, which, like its most recent incarnation, aimed to assess attitudes toward saving and investing.
Arguably, these results are encouraging, in that the survey asks whether investors have ever been approached with a possibly fraudulent investment opportunity or if they have ever invested in a fraud — not whether these events have occurred in the past two or three years. So, the fact that these rates are more or less unchanged suggests that the prevalence of financial fraud is not growing.
But fraud is nonetheless still a serious problem. Overall, the survey puts the incidence of financial fraud at 4% (the latest data from Statistics Canada put the annual rate of fraud offenses at less than 0.3%). More worrying is the fact that the rate of repeat victimization appears to be rising. Although the these rates are little changed from 2006, there has been an increase since the 2007 version of the survey.
This year’s survey found that 21% of fraud victims report being victimized twice and 8% say they have been victimized three to five times, vs 18% and 5%, respectively, in 2007. In addition, the amounts victims are risking in these schemes are also increasing: 38% report that they have invested more than $5,000; 14% have put more than $25,000 into these sorts of scams. These figures are up from 32% and 12%, respectively, in the 2006 survey.
There is no single defining characteristic of those who are likely to fall victim to fraud, although the survey reports that they are more likely to be experienced and educated — those aged 55 or older and/or with post-graduate degrees.
Although older, well-educated people may sound like they should be among the best equipped to fend off an investment scam, the finding that they are often victims dovetails with one of the survey’s other notable findings: that fraud victims are typically active, confident investors. “Fraud victims tend to be overconfident and to be more accepting of investment risk,” the survey found.
Not only are fraud victims more likely to be active traders, the survey indicates they are also more ardent researchers (a greater proportion has sought investment information, and inquired into the disciplinary history of a firm or an individual), and they are notably more trusting than the population at large.
The role of trust as a risk factor in investment fraud is an interesting one. Recent research published by the Cambridge, Mass.-based National Bureau of Economic Research looked at the relationship between individual trust beliefs and economic performance. The paper — which was co-authored by Jeffrey Butler, assistant professor of economics at Einaudi Institute for Economics and Finance in Rome; Paola Guiliano, assistant professor of economics at the UCLA Anderson School of Management in Los Angeles; and Luigi Guiso, professor of economics at the European University Institute in Florence — found that people’s individual economic fortunes are tied to their tendency to trust others. This means people maximize their incomes when they hold trust beliefs that are about average for their society; those who are more, or less, trusting than average lose income as a result.
The idea that too much trust is counterproductive for economic performance is a novel one because, as the NBER paper points out, trust has been shown to be strongly correlated with per capita gross domestic product, with firms’ ability to grow, with the size of a country’s stock market and with incentives to trade. On an aggregate level, trust is unambiguously a good thing — the more, the better.
@page_break@But individuals maximize their own economic well-being only if they have just average trust in their fellow citizens. “There exists an intermediate level of trust — the ‘right amount’ of trust — that maximizes an individual’s income,” the NBER paper points out. “This amount of income, and trust, will be attained by individuals whose beliefs are closest to the average trustworthiness in the population.”
And having too little trust is more harmful than having too much; the authors found that low-trust individuals have an income that is 14.5% lower than the income of those with average trust, while those with the highest level of trust see their income fall short by 7%.
People who are overly trusting tend to be cheated more often, whereas people who are excessively suspicious may avoid being cheated but also miss out on some profitable opportunities as a result — both groups pay a substantial price for their extreme beliefs, the paper suggests: “Our estimates imply that the cost of either excessive or too little trust is comparable to the income lost by forgoing college.”
The notion that there is some natural limit to trust, beyond which individuals’ economic performance actually starts to suffer, has interesting policy implications. In general, financial services industry regulators are charged with working to bolster confidence in the system; without trust, the financial system utterly breaks down, as the global financial crisis has made clear.
However, the fact that there is some individual economic cost to excessive trust suggests that a little regulatory failure can be a good thing. Although no one at the regulators is pleased that a massive fraud, such as the Bernie Madoff scandal in the U.S., continued undetected for years, its ultimate discovery may have some positive effect — in that it serves as a stark reminder to investors to be skeptical.
“Given the carnage these frauds and scandals cause and the real damage to peoples lives,” says Susan Wolburgh-Jenah, president and CEO of the Investment Indus-try Regulatory Organization of Canada, “it’s hard to admit that anything good can result from them.
But, she adds, there may be some good in the message such an event generally sends to both investors and regulators, once you get past the immediate damage it causes: “A major scandal or fraud leads to a lot of negative publicity. [It] makes everyone more aware [and] should result in everyone questioning old attitudes and focusing on the lessons to be learned.”
The tough task is making those lessons stick, Wolburgh-Jenah says: “I think the challenge is not to slip back to old attitudes and a sense of complacency once memories of the scandal grow dim. Human nature kicks in again; people want to believe it when someone tells them he/she can earn 10, 20 or 30 times what a guaranteed investment certificate will earn. [Combine that] with an inherent bias to trust others — it’s easy to forget, until the next fraud happens — and the cycle starts again.”
Thwarting these fraud attempts is a multi-dimensional challenge. Investors have to do more to protect themselves, to be aware of and alert to the “red flags” of fraud — and that is all part of the overall “investor education” mission for regulators. As Tom Hamza, president of the Investor Education Fund, points out, one of the most significant findings in the latest CSA survey is that people seem to know what they should be doing, in terms of taking charge of their finances; they just aren’t doing it. Closing that gap is the trick.
Regulators then, must continue to hammer home their message — “Trust, but verify” — and encourage investors to check registrations and to do their own research.
There’s also a role for the financial services industry. Manarin points out that an important characteristic of fraud victims is that they tend not to consult advisors, relying too heavily on their own judgment. If more of these people did work with a financial advisor, who could provide them with decent counsel and offer a second opinion on possible investment opportunities, she says, “We could only hope that that would impact on the percentage of people who are victims of fraud.” IE
Victim’s trust key to fraud
Attempts shifting towards more personal approaches
- By: James Langton
- October 20, 2009 October 20, 2009
- 10:33