One needs to keep the scepticism high in investing and realise that if something is too good to be true, it probably is
Recently, a few documentaries on Elizabeth Holmes and Theranos and the fraud that the investors in the company were subject to have been released. They make for very interesting viewing. Apart from other aspects of the fraud, an interesting segment in one documentary was an interview with the renowned Behavioural Economist Dan Ariely on why do people lie especially in the business context. Dan Ariely is the author of “The (Honest) Truth About Dishonesty: How We Lie To Everyone – Especially Ourselves”.
Theranos documentaries are not the only ones on corporate fraud that are flying around. There are quite a few on the Fyre Festival, The Volkswagen scandal, Madoff scandal, Enron scandal and so on. Investors lose heavily in most corporate bankruptcies, however, the worst ones are where everything seems to be perfectly alright and suddenly things blow up. Think of Satyam where there were huge bank balances (fraudulent) and suddenly there was nothing.
A little bit of scepticism and some knowledge of human behavioural traits would help in staying away from the worst of the frauds.
Let us look at some of the patterns in human dishonesty:
• Commitment bias: No one likes to be publicly shamed or proven wrong. If we have publicly promised something or we have cultivated a certain image, we want that to hold good. A company CEO who has projected a 30% sales and profit growth publicly will want to be good on that promise rather than having to answer journalists as to why promises could not be kept.
• Near misses: Let us continue with the example of the same CEO. If instead of a 30% sales growth, the company is facing a 50% sales fall, there is not much that the CEO can do. However if the growth is 25% instead of 30%, there may be a temptation to fudge numbers a bit.
• Slippery slope, small wrongs: Once wrongdoing happens and it is not discovered and people justify it to themselves the temptation to scale up the wrongdoing just a bit gets bigger and over time it grows to gigantic proportions.
• Peer group: If similar others are taking risks or are reporting numbers incorrectly, the temptation to fall in line increases. If most banks are underreporting NPAs, the temptation to do so goes up even for a clean bank. If most banks are underreporting sub-prime losses, everyone else would tend to do the same.
• Probability and consequences of getting caught: If the probability of getting caught is low and the consequences of getting caught are not that high, offenses may go up. If there are many CCTV traffic cameras and the fine is Rs 1,000 for jumping a signal, the offenses would be lower than a situation where the signal is unmonitored and the fine is just Rs 100. Regulated sectors with periodic inspections would have lower rates of frauds than completely unregulated sectors with no outside supervision. A regulated capital market participant would be more reliable than a tipster or a website operator offering to double money in a short time.
• Just cause: Wherever the cause is seen to be good, people tend to justify frauds. For example, if someone thinks that saving this company by committing fraud will save thousands of jobs, that person may be self-justifying the wrongdoing and may not fear the consequences.
• Entitlement: People who by their behaviour convey a sense that they deserve success, wealth, fame, power, etc. are more prone to frauds than people who have simpler needs and are focussed on doing the work. Someone used to corporate jets, fancy parties and page 3 lifestyle may fight desperately to maintain that come what may.
Biases leading to pitfalls
• Halo effect: In Theranos, there were many famous and respected people as investors and board members. This caused new investors to be trusting and to suspend disbelief. This kind of tendency is called the halo effect and can be harmful to investors.
• Representativeness: People tend to associate past successful traits to current situations. Bill Gates and Mark Zuckerberg were dropouts from famous universities. This caused investors to think that Elizabeth Holmes, a Stanford dropout would also be successful.
• Naive extrapolation: It was repeatedly said in the context of Theranos that while computers had reduced in size and cost and increased in speed, memory and functionality, nothing similar had happened in the medical field. What needs to be realised is that not all cost curves and technologies move in a similar fashion. Thus while computing costs generally come down over time costs of metals or energy may or may not.
While there are no foolproof tests (after all we cannot run polygraphs and narco analysis on corporate managers), there are plenty of books and documentaries which give a background in lie detection. One needs to keep the scepticism high in investing and realise that if something is too good to be true, it probably is.(The author is Chief Investment Officer & Director, PPFAS Mutual Fund. Views are personal.)