Is your default “trust” or “no trust”?

After the accounting scandals earlier this decade (think Enron and WorldCom) many economists were puzzled as to why investors didn’t pick up on problems sooner. Why weren’t the accounting firms that supposedly checked up on these guys under more scrutiny? Why were they still not under more scrutiny after Enron blew up and accounting firm after accounting firm was revealed to be pandering to company executives?

Some economists decided that we were just naturally trusting of certain kinds of relationships. That might sound ridiculous until you start to think about it.

When I choose a contractor to renovate my kitchen, my default is “no trust”. I’ve heard enough contractor horror stories that I’m going to want references and a contract that spells out what happens if he misses deadlines.

Do I show the same distrust with my doctor, lawyer, or hypothetical kid’s teacher? For whatever reason—government regulation, certification boards, or whatever—I’m just more naturally inclined to believe the opinions that those types of people give me.

Some of this is changing of course. The performance of doctors and teachers in particular have been under intense scrutiny. But they’re still professions that I just kind of assume are doing their jobs in the right way, in the same way that investors might have been assuming that Enron’s accountants were doing their jobs.

Even though more kitchen contractors might be skeezballs than doctors (no offense, contractors!), when that doctor, lawyer or accountant does abuse that default of trust, the potential consequences are much more dire. You expect that contractor to have surprise expenses and delays. If the other guys rip you off, you might be blindsided.

Now, you just know that some economist, somewhere, had to go out and devise a diabolical “distrust game” to see the impact of trust or distrust in action, right?

The distrust game

In case you’re not familiar with our new game’s predecessor, lets do a quick review of the “trust game”. In a typical version of the trust game, two players, Joe and Brian, get $10. First, Joe decides whether or not to send some or all of their money to Brian, and the money he sends triples. Then, Brian decides whether or not to send some of the money back.

So…say Joe trusts Brian completely and sends $10 over, which turns into $30. Now Brian, who has $40, can reward his trust by sending $20 back and splitting the take, can keep everything for himself, or do something in between.

Anyway, economists at Harvard decided to devise a new experiment where players take money from each other instead of giving it.

Eric starts with $0, and James starts with $40. In stage one, Eric can take up to $30 from James, but his take would actually be what he steals divided by three. So for example, Eric can take $30, leaving James with $10 and himself with $10.

Similar to the regular trust game, in stage two, James decides how much of the remainder to send to Eric. If Eric left him all $40, he could just keep all $40 for himself or reward the trust by splitting the pot.

Get it? Kind of like the trust game in reverse.

The Harvard professors tried out both the trust and distrust games on 134 college students to see if their behavior differed.

Uh, can you please make that understandable?

Sorry the games are hard to follow. I wish I conjure up a little widget so you could play the games yourselves, but the bottom line is this. In the trust game, the default is to not trust someone. You have to choose to give over part of your cash in order to have the possibility of the second player rewarding that trust or screwing you over.

In the distrust game, the default is to trust. You have to consciously decide how much you don’t trust the guy and take money from him before the second stage.

As the experimenters predicted, with the new game, students were more prone to leave money in the hands of the second player. And in return, they actually got screwed over more often. Nice.

People don’t distrust enough.

At least, that’s the conclusion of the Harvard researchers. But more than that, the researcher plays into the ongoing collection of research that shows we’re lazy bums. We’re creatures of inaction and defaults.

Fixing defaults in other areas of our lives is pretty straightforward. You set up automatic deposit on your IRA to take money from your bank each month and don’t have to worry about taking the action to invest 12 times a year.

But how do you fix a problem that involves a default feeling and one that you might not even know is bad? A couple decades ago, doctors were gods. Even now that we have more accurate performance measures and know about countless times doctors have screwed up, it’s never crossed my mind to get a second opinion. In the same way, I’ve just kind of assumed my lawyers had my interests at heart and teachers were telling the truth.

Is that even something we should fix? I’m at a loss. It would be exhausting to have to second-guess everyone who provides a service.

Or, why smart people fall for stupid cons

Sometimes, it mystifies me that so many people can fall for the oldest tricks in the book. Bernie Madoff’s operation was nothing more than a Ponzi scheme—you know, that scam that was invented in the 1920s. Do people really think that a random Nigerian prince selected them to handle gigantic sums of money? Does it really never occur to a tourist that a street-side card game probably isn’t on the up and up?

It mystifies me, that is, until I fall for one. Then the excuses get rolled out. Even in hindsight, you try to convince yourself that you’re not a sucker. There was no way you could have seen that coming.

So why is it that we fall for these silly cons? Researchers at the University of Cambridge decided to figure it out and boiled down their findings to seven principles that make us more prone to being tricked. I am simmering those down to four, because I found them the most interesting. But check out the whole study if you’re curious. Here they are, with direct quotations in italics:

1. The distraction principle

While you are distracted by what retains your interest, hustlers can do anything to you and you won’t notice.

Here’s what I want to know: In the Wizard of Oz, what took Dorothy and her friends so long to notice the man behind the curtain? I bet the giant, green, booming head had something to do with it. If you think about it, the man was really nothing more than a high-tech magician. Set up a big distraction, and you’ll keep their eyes away from where the real magic happens.

In the scammer world, this takes many forms. The street performer holds your attention, while a pickpocket works behind the crowd. A thief runs off with a woman’s purse at the airport, and while you’re in pursuit, the woman takes your luggage. It’s often hard to distinguish between a real distraction and an illusory one. So my advice would be to assume that they’re all fake, especially if you’re a tourist.

In the legal-but-shouldn’t-be world, you’ll get annuities salesmen trying to focus your attention on guaranteed returns, instead of high, back-end fees and surrender charges. Or maybe you’ll get a car salesman who lures you in with a low base price, but shows you the “delivery charge” after you’re already committed.

In one world, the perpetrator gets arrested, but let’s face it, it’s all the same.

2. The herd principle

Even suspicious marks will let their guard down when everyone next to them appears to share the same risks. Safety in numbers? Not if they’re all conspiring against you.

In the scammer world, the “herd” is the group winning money in the street-game you’ve stumbled upon. You think the game must be honest, because these guys win, right? Of course, it turns out that they’re all in on the con.

It wasn’t the study’s authors’ intention, but it’s oh-so-tempting to turn this into an investing lesson too. As a species, we get a lot of comfort in knowing that there are others succeeding or failing with us. Even if you think tech stocks are overpriced, if your neighbors are all making a killing in the sector, you’re tempted to buy in. Yes, you’re also jealous of their success, but if you fail, they fail. That feels good. It feels safe.

Of course, the scammers take it a step further. Not only are the playing off that safety-in-numbers, prehistoric mentality, they’re not actually sharing the risks.

3. The deception principle

Things and people are not what they seem. Hustlers know how to manipulate you to make you believe that they are.

One of my favorite scenes in Casino Royale is when a tourist in a hurry throws James Bond his car keys, thinking he’s the valet. I’ve got to admit, I don’t think I’ve ever questioned whether the man in uniform in front of the hotel worked there. Even if I did question it, I’d probably be too embarrassed to ask.

The BBC apparently tested a scam where they set up a fake ATM machine to see if pedestrians would be fooled and use their cards there. Of course, if they were real fraudsters, they’d get all of the customers’ debit card info and PINs. The operation worked better than they hoped for. You see, before they had even finished building the machine—that is, even while the machine’s back was exposed to the air—people kept walking up and trying to use it! Talk about “blinded by familiarity.”

Ever see an ad proclaiming “8% yield! Better than a CD!” in big letters and “Not FDIC-insured” in small letters? The bringer of this great investment opportunity is lowering your guard with a comparison to something you’re familiar with.

4. The need and greed principle

Your needs and desires make you vulnerable. Once hustlers know what you really want, they can easily manipulate you.

Ooh, it’s tempting to turn this one into an investing principle too. But staying on point: Find out what your mark wants more than anything, and then offer it to him. If your target is bankrupt, offer him money. If your target is lonely, offer him companionship. Afraid? Offer safety.

I could go on and on. But people do stupid things when they need something desperately. And that’s why even though we all roll our eyes when we hear about someone falling for the Nigerian Prince scam, none of us are safe from it—not if we were put into the right predicament.

Not all cons are illegal.

I hope you find ways to apply these principles in everyday life. People are trying to sell you all the time, and even though it’s not classified as fraud, oftentimes the sell works off these tenets. Everyone’s running a con. And knowing yourself goes a long way to stopping it.

Ed’s Note: Ok, an admission here. Astute readers will notice that this image has been used twice. No, I don’t plan to do that with regularity. I took down the first post with which the image ran—a rant on free credit report commercials—because it was, well, a rant. I looked at it a few days later and decided that’s not what this blog is about. So bear with me as I grow into the blog. Thanks for reading.