Tuesday, September 22, 2009

Fraud and motivated reasoning

Have you ever wondered why some victims of fraud end up believing the fraud perpetrator is innocent long after a loud and clear signal that they have been duped has been revealed?

I observed this behavior in a profound way a few years back when Charis Johnson was accused with strong evidence that her "12 Daily Pro" investment was no more than a Ponzi scheme. Charis was paying 12% interest per day and she had many followers who knew she was a saint because she was paying them this outrageous interest rate which compounds to an absurdly enormous rate of return. I calculated at the time that $1.00 invested in 12 Daily Pro would grow to 9,217 trillion dollars in one short year if interest was compounded daily! That amount was 333,000 times the US federal budget for 2007 when 12 Daily Pro was running strong!

I would think that any reasonable person who had these facts explained to him or her would be outraged at Charis and be thrilled to learn what was necessary to avoid future losses. However, when the Dean of BYU's Marriott School of Management explained that 12 Daily Pro was a scam, he received death threats from investors around the globe. In addition, numerous people ridiculed him for suggesting that this scam could not be based on anything short of a pyramid scheme. Why so?

It turns out that the 12 Daily Pro story above is not unusual. In fact, many people become committed to an idea and then justify the idea both emotionally and cognitively. They end up reasoning in a way that allows them to keep their belief, even when facts suggest otherwise.

A recent article in the NY Times explained how this took place decades ago when two explorers claimed to make it to the North Pole. Both are now believed to be frauds. However, at the time they had many believers who refused to see the facts as they were due to what is known as motivated reasoning. Motivated reasoning can be very costly to victims of fraud schemes. It's likely that many of Bernie Madoff's investors had clear signs that the scam was a fraud, including articles in Barrons and other warning signals. However, they were getting their returns so they found a way to dismiss the warning signals.


  1. Madoff had the ultmate All-Clear/Safe to Invest approval from the SEC year after year--they investigated four or five times starting in 1992 and found nothing, due to sheer incompetence or perhaps willful ignorance. Markopoulos brought them clear evidence that it was a fraud, and they completely dismissed it and him, continuing to say it was a completely safe investment. If you had a choice between a Barrons article and the US government continuing to tell you it was safe, who would YOU believe?

  2. @ Madoff Survivors: I imagine that just about everyone engages in motivated reasoning at some point in his or her life, whether it be in relation to an investment decision, a political opinion, or some other thought process. Avoiding motivated reasoning in our investment decisions will help us be more objective in managing our savings and will hopefully help us steer clear of people like Bernie Madoff. The whole idea behind motivated reasoning is that we tend to give more credibility to sources of information that support our beliefs and we tend to discount information that contradicts our beliefs. As an example, some of Madoff's investors were more inclined to believe the SEC over the Barrons article because they wanted to continue to receive Madoff's high returns, whereas Markopoulos would probably have believed the Barrons article over the SEC (see today's post for more on Markopoulos and the SEC).