Too good to be true?

Posted by on February 17, 2009 @ 9:58 am in investing

Once again, we read the sad headlines about investors misled by an investment manager who had a “sure thing” investment strategy that led to a devastating outcome.

The size and scope of the recent debacle appear unparalleled, raising painful questions: Why do these things happen with some regularity—and to people we consider sophisticated? Why don’t we learn from past mistakes, especially since so many of them have been widely publicized?

Robert Cialdini, a professor of psychology at Arizona State University, was quoted in a recent Wall Street Journal article (subscription required) pointing to three elements that contribute to bad investment decisions made by smart people:

1. The opportunity has an air of mystery about it, and only someone who’s smarter than you are can figure it out.

2. Other people you trust are doing this, and there’s a sense that you need to move quickly or you’ll get left behind.

3. Since you know others have been successful—and they’re smart people—you don’t need to ask as many questions as you otherwise would.

Given this knowledge, how can we create an early warning system in order to protect ourselves from schemes like this in the future?

First, it’s important to acknowledge that “people factors” are as much at work in the world of investing as are the principles of finance. A yearning to be part of something that’s exclusive, a willingness to trust others we know and respect, and a desire for success are all part of our human nature.

Second, we can never ask too many questions—perhaps even requesting that results be independently verified by third parties. Apparently, in this most recent situation, a few basic inquiries about accounting practices and SEC investigations would have been sufficient to at least raise a red flag or two.

Finally, at the risk of stating the obvious: Remember, if it sounds too good to be true, it probably is.

Notes:

All investments are subject to risks.

The link to WSJ. com will open a new browser window. Vanguard accepts no responsibility for content from third-party publications or websites.

We invite your comments on this Vanguard Blog entry. Comments will be monitored and published at Vanguard’s discretion. Comments received prior to July 7, 2009 will not be published.

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