Many people fall victim to investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition fraud every year. Fraudsters may use clever tricks or technology to their advantage, but often times, they take advantage of our human nature, exploiting our behaviour.
We rely on intuitive judgments when making decisions. In complex financial situations, we may use intuition to help simplify our decision-making process but it can also lead to unwanted outcomes, like falling for an investment scamScam When someone tries to make money by misleading or tricking another person.+ read full definition. By understanding our behavioural biases and decision-making processes, we can better protect ourselves from investment fraud.
6 behavioural biases that fraudsters exploit:
Trust is an important part of any healthy relationship, but blindly trusting others can lead to problems. We tend to trust those that they know like our friends, family, and acquaintances, people with good reputations, or those who seem to be endorsed by a trustworthy source. Unfortunately, fraudsters exploit our tendencies to trust others and may target us through community groups, clubs and other organizations that we may be a member of. Affinity fraud is when a fraudster takes advantage of their relationship with you or a group that you belong to, with the hopes that you’ll automatically trust their advice rather than on carefully assessing the investment opportunity.
Always check the registrationRegistration A requirement for any person or company trading investments or providing advice in Canada. Securities industry professionals are required to register with the securities regulator in each province or territory where they do business.+ read full definition of any person or business trying to sell you an investment or give you investment advice. Visit CheckBeforeYouInvest.ca
The halo effect is a cognitive bias in which an assessment of one characteristic influences your perception of that person’s other unrelated attributes. For example, people who are judged to be physically attractive or friendly are also likely to be considered more trustworthy even though one does not imply the other. The halo effect is also commonly exploited in affinity fraud. For example, a fraudster will infiltrate a volunteer group or religious community to befriend the members. The fraudster’s friendliness causes victims to overestimate their trustworthiness due to the halo effect.
Representativeness is when we judge the likelihood of an event based on its similarity to another event. For example, if a coin is flipped and lands on heads 9 times in a row, we may be certain that the next flip will be tails but the probability is still 50/50. In pump and dump scams, the fraudster will take advantage of representativeness by artificially driving up the price of a stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition over a short period of time. Dramatic and predictable increases in stock prices are incredibly rare, but victims ignore this base-rate due to representativeness.
Confirmation bias means that we automatically look for information that supports our prior beliefs because we seek affirmation of our views. This causes us to ignore or dismiss any information that may lead a different conclusion. For example, if you believed that a tech stock should increase, you might only look for news stories that praise the company instead of looking for evidence of flaws with the company.
Optimism bias can happen when you overestimate the probability of positive events and underestimate the probability of negative events. This bias may lead you to overestimate the trustworthiness of potential fraudsters and underestimate the likelihood of being offered fraudulent investments. In reality, 5% of Canadians report investing in a fraud. The actual number is much higher since many cases of fraud go undetected or unreported. This bias is related to all types of investment fraud.
Regret aversion occurs when you are afraid that your decisions will be wrong in hindsight. This bias can occur due to action (selling a stock too early) or inaction (not buying a stock that dramatically increases in price). Regret aversion causes people to think about the worst-case scenario and imagine the amount of regret that they would feel in that scenario (rather than thinking of all potential outcomes). This effect contributes to boiler room scams. These fraudsters will use high-pressure sales tactics to convince you to investInvest To use money for the purpose of making more money by making an investment. Often involves risk.+ read full definition in an amazing opportunity. Since the promised returns are so high, victims perceive regret to be higher for inaction and ignore the possibility of losing their initial investment.
It’s sometimes tempting to make a quick decision or take shortcuts to help simplify financial decisions. It’s human nature and fraudsters know this. Always follow these 4 steps to help protect against investment scams.