Gullibility - How Not to Get Caught Out

By Jason Fittler

"Good advice sometimes saves you more money than what you will make from it."

When markets fall we start to see which investments are genuine and which are cons, we also start to understand what risk return is all about.

Over the past couple of years we have seen a number of investments go under such as WestPoint, Fincorp, ARC, MFS Limited now the Madoff Ponzi scheme and in Townsville the collapse of Storm Financial.

But the real question is why do people keep investing in such schemes?  And how do you avoid falling into this trap? It is my belief that education is the best form of prevention. The better your knowledge on this issue the better equipped you will be to avoid losing your money.

There are two steps; first is understanding why people continue to invest in such schemes, and second is to understand how to identify such schemes.

Understanding why!

Over the years there have been many such schemes and many different people caught by them. The quick answer is that the investors are greedy or lack intelligence; this is in fact not true. Over the years many knowledgeable people have lost their life savings in such schemes.

One famous one was the South Sea bubble, when British South Sea Co was formed in 1711 they promised a monopoly on trade to the Spanish colonies. It lured investors with the promise of riches from abroad. Prices of shares spiked and then collapsed in 1720, Sir Isaac Newton lost the modern day equivalent of about $1 million.

What is Gullibility?  It is a sub type of foolish action, which might be termed “induced-social”. It is induced because it always occurs in the presence of pressure or deception by other people.

There are generally four factors which increase gullibility.  These are Situation, Cognition, Personality and Emotion. These are detailed below, the trick is to be able to identify them in you and stop yourself before it is too late.

Situations. Every gullible act occurs when an individual is presented with a social challenge that they have to solve. In the case of a financial decision, the challenge is typically whether to agree to an investment decision that is being presented to you as benign but may pose severe risks or otherwise not be in one's best interest. Assuming that the decision to proceed would be a very risky and thus foolish act, a gullible behavior is more likely to occur if the social and other situational pressures are strong.

Cognition. Gullibility can be considered a form of stupidity, so it is safe to assume that deficiencies in knowledge and/or clear thinking often are implicated in a gullible act. By terming this factor "cognition" rather than "intelligence," indicates that anyone can have a high IQ and still prove gullible, in any situation. There is a large amount of literature that shows how often people of average and above-average intelligence fail to use their intelligence fully or efficiently when addressing everyday decisions. Never confuse rational and intelligence. Intelligence is the possession of cognitive schemas while rationality is the actual application of those schemas. It is the "pump" that drives irrational decisions which, is the use of intuitive, impulsive and non-reflective cognitive styles, often driven by emotion.

Personality. Gullibility is sometimes equated with trust; however, not all highly trusting people are gullible. The key to survival in a world filled with fakers or unintended misleaders who were themselves gulls is to know when to be trusting and when not to be.

Emotion. Emotion enters into virtually every gullible act. The emotion that motivates gullible behavior is excitement at the prospect of increasing and protecting one's wealth. In some individuals, this undoubtedly takes the form of greed, but I think that truly greedy individuals would more likely not have been interested in the slow but steady returns posted by the above investments funds.

Understanding How!
 
The key to identifying such schemes is simple and I am always reminded of the old saying “If it looks to good to be true then it most likely is.”

The key points are as follows;

1.    Education – first before you even start to invest make sure that you understand a little about what you are doing and trying to achieve. Education comes from books, not from newspapers, television, one day courses with the company you are looking to invest through, salesperson or the internet. I am not saying get a degree in the subject but at least get an understanding of the key issues.

2.    Research – make sure that you research other investments which are similar to the investment you are looking to undertake. The returns should be similar if they are not then your risk is different, it is that simple. Make sure you fully understand the nature of the investment. Speak to other providers of similar investments.

3.    Advice – make sure you get a couple of opinions, do not be afraid to pay for advice. A little money up front may save you a lot down the track. The more advisers you speak with the better as they will all have a slightly different perspective on the investment.

4.    Read – make sure that you read the Statement of Advice provided to you from the adviser. Make sure that you read the prospectus so that you fully understand the pit falls of such an investment. Clarify any points you are not sure on with your adviser.

A little hard work at the start will save a lot of heartache down the track. I have seen the devastation caused from people losing everything through bad investments; I can assure you that these are good hard working everyday people and not greedy people who got what they deserved.

Good advice sometimes saves you more money than what you will make from it.

Until next week.