Is Investor Skepticism Learned or Innate?

A study examines the role of financial knowledge and personality traits when judging investments.

(Illustration by RIA Intel/Bigstock photo)

(Illustration by RIA Intel/Bigstock photo)

A recent academic study investigated the extent to which nature and nurture inform investor skepticism.

In a paper titled, “Who Gets Duped? The Impact of Economics and Finance Education on Skepticism in an Investment Task,” professors at the College of Charleston, S.C., examined personality traits as a proxy for nature and economic and financial education/literacy to represent nurture.

“On the nature side, we are interested in examining the extent to which immutable aspects of one’s personality affect skepticism. Is there a skeptical personality?” the professors asked. Per nurture, the professors focused on the impact of education.

Survey participants included a group of graduate and undergraduate students from the College of Charleston with a variety of finance and economic backgrounds, “ranging from no prior coursework to extensive coursework.”

The participants were asked to analyze four different hypothetical funds and recommend one. These are based on actual investments though their names were changed. One was based on Bernard Madoff’s fund.

Participants received detailed information about each fund. Importantly, they were given the opportunity to request more information about each option. Doing so would reveal the fund’s investment strategy and auditors.

Participants then completed the Big Five Personality Inventory (BFI), which measures participants on the traits of extraversion, conscientiousness, agreeableness, neuroticism, and openness.

The authors hypothesized that more finance education/literacy would correlate with increased skepticism and that certain personality traits would reduce the likelihood of the Madoff fund being recommended.

Results indicate that education matters more than personality.

“More education in finance is associated with a lower chance to be a victim of financial fraud,” Calvin Blackwell, Professor of Economics, Department Chair, at the College of Charleston, and an author of the report, told RIA Intel. “These are skills that can be taught,” he said.

“We find that although the impact of personality is complex, more coursework in economics and finance appears to cause students to ask for more information and raises suspicions regarding the Madoff fund, which in turn reduces the likelihood that the Madoff fund will be recommended,” the report said.

Surprisingly, the study indicated that nearly 46% of students chose the Madoff fund, which was “far more” than other options. Only 7% chose the Standard & Poor’s 500 Index. Those more knowledgeable about economics and finance were more inclined to ask for information and “more likely to recommend the S&P 500 over any of the funds under consideration.”

The authors argue that skeptical investors could have sniffed out problems at what would become the largest Ponzi scheme in history. “Madoff’s funds claimed to consistently earn above-market returns with little apparent risk, even though modern portfolio theory suggests such results are highly unlikely.”

They cite Harry Markopolos, who armed with public information concluded in 2000 that Madoff was a fraud. Markopolos warned the SEC multiple times, including in 2005 when he submitted to the agency a report titled “The World’s Largest Hedge Fund Is a Fraud.” Madoff’s Ponzi scheme unraveled three years later.

Citing Markopolos as someone who appeared to be “low on agreeableness,” Blackwell told RIA Intel that his initial hypothesis was that people who ranked low on agreeableness might be more skeptical. However, in terms of a correlation between personality traits and investor skepticism, Blackwell says “the evidence is fairly weak.”

Although Madoff is estimated to have defrauded an estimated 38,000 victims, the authors estimate that up to 11% of the U.S. population has been victimized by financial fraud.

The authors note that a seemingly intractable obstacle in thwarting fraud involves the Truth Default Theory, “a comprehensive theory of deception and deception-detection,” coined by Timothy Levine, Distinguished Professor and Chair of Communication Studies, University of Alabama at Birmingham. One of the theory’s key assertions is that “people presume honesty in communication” and that it is “evolutionarily adaptive” to assume honesty.

The authors also cited research by Brian Knutson, Professor of Psychology and Neuroscience at Stanford University, and Gregory Russell Samanez-Larkin, Assistant Professor of Psychology and Neuroscience at Duke University, who found that “investors with reduced impulse control were more likely to fall victim to financial fraud, while neither cognitive ability nor risk attitude helped to explain susceptibility to fraud.”