The fascinating psychology of scams: Why they work and how to spot them

We’ve all heard about or seen a scam from a ‘Nigerian prince’ who needs your short-term financial help, with the promise of huge wealth in return. Despite the grammatical errors and the unoriginal storyline, for many it’s too exciting to totally ignore. Yes, these scams still work and always result in an unfortunate victim.

You may think that you can spot a scam like this a mile away, but modern successful scams are not all as obvious as this. Scams evolve over time.

I recently read a great book by Ben Carlson called Don’t Fall For It on scams throughout history. It was a fascinating read – not just about the vast wealth that has been lost to scams throughout history, but also the psychology behind how we make financial decisions. These scammers and charlatans tap into the irrational ways we often make decisions, and that’s why scams can still work.

Why do scams work?

Scams are often more successful in good economic times, when people are more prone to let their guard down.

This is particularly relevant to Australians right now because, while there are undoubtedly events that cause us concern, we’ve enjoyed almost 30 years without a recession and the ASX continues to hit new highs. From a historical point of view, the past three decades have been extremely positive for Australia – no other country comes close to our economic record.

This is important because in good economic times there will always be a portion of the population making a lot of money, which can affect our emotions. There’s a famous line by JP Morgan, that “nothing so undermines your financial judgement as the sight of your neighbour getting rich”,

Whether it’s your neighbour, a friend or even someone on social media, when we see other people making a lot of money we can be susceptible to irrational decision making. To keep up with their lifestyle we may fall quickly into debt as we get influenced by FOMO (fear of missing out). FOMO is so powerful that we may also become more open to quick, new ways to get rich quick! This can be why scams are more effective in good economic times. Have you ever noticed these influences affect your spending?

Scams also often have exciting stories attached to them designed to elicit emotion, such as the hype around a new kind of technology. Recently two fraudsters were caught for their role in a $30 million ICO (initial coin offering) that ran throughout 2017 and 2018 under the guise of providing technology for hedge fund operators. It was nothing more than a scam.

There’s also the recent failed IPO of WeWork. While not technically a scam, it was the greatest wipeout of shareholder wealth since the Enron fiasco. Many investors, including sophisticated, professional investors, got caught up in the exciting story that was attached to WeWork.

Scams can often be complex and hard to understand. This is because scammers know that no-one wants to appear stupid. The more complex the “opportunity” the more it requires us to place our trust in them.

You would think that the internet has levelled the playing field by providing a way to easily screen for scams, but that’s why there’s usually some form of exclusivity to the offer to make us act now. It’s often framed as a once-in-a-lifetime opportunity but the reality is, it’s getting peddled to people every day. If anything, technology makes it easier for scammers to reach more targets.

So, in short, if someone offering a financial opportunity tries to convince you that you’re going to miss out, tells exciting story, makes their deal or prospect hard to understand, and insists you must act now, think carefully before going any further.

How can you avoid being scammed?

• Do your homework. Many people spend more time researching a new TV than they would choosing a stock or an ETF.
• Say no to something if it’s too complicated to understand. You need to understand how it works and be realistic about the likely return. If it sounds too good to be true, it probably is.
• Don’t confuse investing and entertainment. Often the best investing is boring.
• Diversify. As tempting as it is to maximise your stakes on ‘certainties’, it’s not always how things unfold. The future is uncertain and diversification protects against an unknown future.
• Look to people with a proven track record, not simply an interesting story.

If you would like to hear more about Ben and his book Don’t Fall for it, I recorded a podcast with Ben, in which we discuss his research into infamous scams over history (including the story of how a charlatan fraudulently sold someone the Eiffel tower not once … but twice!).

IMPORTANT LEGAL INFO This article is of a general nature and FYI only, because it doesn’t take into account your financial or legal situation, objectives or needs. That means it’s not financial product or legal advice and shouldn’t be relied upon as if it is. Before making a financial or legal decision, you should work out if the info is appropriate for your situation and get independent, licensed financial services or legal advice.