The Compound and Friends - How To Avoid Financial Fraud (with Barry, Michael, and Ben)

Episode Date: January 31, 2020

Barry and Michael sit down with Ben to discuss financial fraud and his new book "Don't Fall For It: A Short History of Financial Scams." Pick up a copy of Ben's book: https://www.amazon.com/Dont-Fall-Short-History-Financial/dp/1119605164 1-click play or subscribe on your favorite podcast app   Subscribe to the mini podcast on iTunes or Spotify    Enable our Alexa skill here - "Alexa, play the Compound show!"   Talk to us about your portfolio or financial plan here:  http://ritholtzwealth.com/   Obviously nothing on this channel should be considered as personalized financial advice just for you or a solicitation to buy or sell any securities. Please see this 3,000 word terms & conditions disclaimer: https://thereformedbroker.com/terms-and-conditions/ Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

Hi, I'm Barry Ritholtz, and we are here with esteemed author Ben Carlson discussing his new book, Don't Fall For It, A Short History of Financial Scams. Ben, welcome to The Compound. Thanks for having me, guys. So tell us a little bit about what motivated you to write a book about financial scams. You got defrauded, didn't you? It was the Nigerian Prince scam that got me the email. So convincing. Yeah.

Somehow people fall for that. I actually found that dates back to not the email part, but the actual scam of saying a prince has all this money. You just have to pay $5,000 and someone will get it for you because this king left all this money for someone for an inheritance. That dates back to like the 1400s. So people have been working on that one for like 600 years still what are the letter travel by lamb carrier pigeon i guess i i got interested i mean there's a lot of the stuff going on lately i'm just kind of over the success story stuff the here's someone that hit a home run and let's let's backtrack and figure out how they did it whereas i've been more interested lately in the, the fire festival guy, uh, Billy McFarlane and Theranos with Elizabeth Holmes,

figuring out how someone was able to pull this stuff over on people. And I just became really interested in that and started pulling on a thread and reading a few stories and doing some research and just realized like some of these stories are amazing, how people can be duped over and over again in similar ways throughout history. And then I started weaving in, well, there's a behavioral psychology element and there's a market element because this often happens during bull markets. There's a technology element because a lot of this happens during

times of innovation. So I just started pulling on the thread a little bit and just realized it was a really interesting topic. So one of the commonalities amongst all these chapters is that obviously these people are cooks, they're thieves, they're charlatans, they are ripping people off. So my favorite part of this book was the way that you described these people, type one charlatan and type two charlatan. What are these type one and type twos and where did you get that idea? Was that yours or did you pull it from somebody? Robbing fast and slow. And the crazy thing is about how these are criminals, but I ended up kind of liking some of them after doing the research. There's obviously

some of them that are just deplorable, but there are some of them that you're like, man, the way that they went about this was just such a, you almost like, and even the people who got scammed by them sometimes would like them. There was a guy who showed up to a funeral of John Brinkley, who was a doctor who scammed all these people by doing these fake medical procedures. And the guy at the funeral said, man, I know he built me out all this money, but I still liked him anyway. And so anyway, the type one, type two, I think I actually did come up with myself. It was using the boring statistics term where there's type one statistical error is a false positive. You know, you point to a man and say you're pregnant and

then type two statistical error is you point to a woman who is pregnant say you're not pregnant and i was reading through these stories about there's the south sea and mississippi bubbles which happened almost right on top of each other and there's like a hundred books on these on this subject and i wanted to figure out well what's an interesting way to retell that story that's already been told a hundred times? And the way to do it was looking at the two people who pulled off the heists and the scams, and one of them was a guy who just tried to do it the right way, and he had good intentions and started off with a good idea and took things too far.

That was John Law, and the other guy took things the other direction, and he just out and out decided, John Blunt decided to scam people, and that was the Law. And the other guy took things the other direction and he just out and out decided, John Blunt decided to scam people. And that was the South Sea bubble. And so it was two people who got into the same place. They made a lot of people lose a lot of money, but they went about it at a different way. So one of them was the person who is very sincere in what they're doing and they still took people for all they're worth. Type two would be the person who sets out to out and out scam you, and that's their main goal is to just take some money. I had it backwards.

I thought the type one was the person who was just a thief, and the type two was the person who believes their own bullshit. I mean, it was basically a truce fall, so you had a 50-50 chance of guessing. So did Bernie Madoff start out as a type one and then become a type two? I didn't even want to get into Madoff much from his point of view. I wanted to look at it from the victim's perspective. That was the difference in this book that I did too because a lot of people have heard about him.

So I guess you could say I think he was just such a sociopath that he was probably more of a type two. The whole time? I think so. Because we don't really know when what started out, what looked like a legitimate trading firm. I mean, he was on the board of directors of NASDAQ back in the day. When did he just go full blown? Oh, this is just a complete. We know it's at least 20 years ago, but no one really knows exactly where that line is.

Maybe he was a type 1.75. But there was this guy, Ivor Kruger, who ran this match company and this is in the 1920s and when he started the company in the teens and up through the 20s, he had this legitimate business of, it was a monopoly

but it was legitimate for back then where he basically owned and controlled two-thirds of the match production throughout the world. That was the Match King book? Yeah, the Match King. Frank Portnoy, I think? Yeah, very good, and I read a lot about him. And they can't really figure out when this guy decided to go from legitimate business

to out-and-out scam and fraud that eventually blew up after the Great Depression. And what it sounds like happened to him was he just got too far over his skis, and once he had all this power and money and control he couldn't he just couldn't pull it back so he started cooking the books and running these these crazy schemes where he's paying out 30 or 40 percent dividends on loans that he was getting for five percent so it just he got too far ahead of himself and just couldn't pull it in and maybe that's maybe that's the elizabeth holmes thing too where she thought she could she could really do this and get there before everyone figured out that it was a scam. See, with her, when you read Bad Blood, it's pretty early on it becomes clear that they're defrauding investors.

Well, she thought she could get there before people figured her out I guess. Early on, it was a legitimate idea, although you have to say to yourself how does somebody who has no medical background, no med tech training, think that a finger prick is going to be as effective as drawing blood? Everybody in the medical industry says, no, no, it's ineffective because the process of pricking your finger, it damages cells. It releases all these other things. It was flawed from day one. She just didn't realize it. One of the common elements that runs through a lot of these is just you have this person who can sell a great story and people are always willing to take that story. And that's the thing that runs through all these. So one of my favorite examples are this guy, Victor Lustig, who no one knows what his real name was because he had 45 different aliases, but he's the guy who sold the

Eiffel Tower twice. I love that story. He went to Al Capone when he got into Chicago, and at that time, Al Capone ran the criminal syndicate in Chicago, and you did not do any criming on Capone's turf without asking him first. So he got to Chicago after being pushed out of New York and some of these other places because the authorities were onto him, and instead of trying to work his way in, he went right up to Capone and said, all right, I've got a scheme for you. Give me 50 grand and in a month I'm going to come back with 100 and I'm going to double your money.

I'm not going to tell you how, but I'm going to do it. And Capone says, all right. And he basically said, either this guy's going to double my money or he's going to come back with nothing and I'm going to kill him. And the guy comes back and he hands him his 50 grand and he says, ah, I'm really sorry. It just didn't work out. And Capone was so taken aback by this guy's honesty that he said,

all right, you can do whatever you're going to do with these little scams that you do. And by the way, here's $5,000 to get you started. And the guy walked out of there with a smile on his face because he knew Capone would do this and value his honesty, but he didn't do anything with the money in the first place. He just put it in a safe deposit box, had no plan for it at all, and just was never going to do anything anyway. You thinking what I'm thinking?

Absolutely. We're in. So he sold himself that he was this really great, honest person. And of course he wasn't. He planned this thing the whole time. He just told Capone what he thought he wanted to hear, that he was dealing with this really honest person. So you have a chapter, When Fraud Flourishes. And if I had to take a stab at this, I would say that people are more likely to be defrauded in bad times because they're desperate. But actually, people are more susceptible to these charlatans in good times. That was something that going into it, I didn't really realize either. And obviously, people can be defrauded at all times. But the common theme was there's a technological innovation. And so the 1920s was by far the ripest time I've ever seen in terms of my research for fraud.

You had all these new innovations coming on board. We had the automobile and people in their houses were getting all these new technologies, dishwasher and washing machine and refrigerator. And people were just so optimistic about the future that they almost didn't care about letting their money on fire. And it's also a time when we had this really great financial innovation, and there was a time where you could finally build some derivatives. And so Wall Street got involved. And the South Sea bubble, too, and the Mississippi bubble, you had these huge financial bubbles.

And so that is a running theme. Of course, the dot-com bubble, there was a lot of fraud there, the real estate bubble, all that stuff. So I just found these themes running through where those times could really just supercharge this stuff. Well, so they get defrauded during good times and the fraud comes uncovered in bad times. Yes, it's the Buffett. We figure out who was naked when the time,

and somehow the Kruger guy who did the match company, he survived the first few years of the Great Depression somehow and did okay. And finally, by the end of it, it all unraveled because it was just impossible when the stock market got crushed so bad to keep it up. A lot of these things seem so obviously nonsensical to us. Why is it that people fall for them? Funny thing that I found with this is that anyone is susceptible to be scammed because of just our human nature. So it's not

just poorly educated people. No. And honestly, it's the flip side of that because it's actually the wealthier and more educated people that do succumb to it more. Obviously, one of the reasons is because they have more money. So they have a target on their back. But there was a study done where they had two big groups of people and they gave them each a test. And it was actually a very thorough test in terms of how do you understand markets and finance and investing. And one group of people had been defrauded financially. The other group had not. And they actually found that the group that had experienced financial fraud scored relatively well on the test, like 60 to 70%. The people who had not been part of a financial fraud scored like

20% or something like that. So the people who actually had a little knowledge to be just dangerous enough to pull them into this thing. And what I really found was that it's another sort of keeping up with the Jones thing where wealthy people want to believe that they have this secret door, secret entrance into these investment strategies that no one else can get into. And they want to believe that just for them, it might sound too good to be true for other people, but for them, yeah, I think this has to be right, right? They're just not offering it to other people because I actually have money and funds and you just get this overconfidence from people that actually have this stuff and have some smarts. And it's kind of crazy that those are the ones who fall prey to this stuff. All right. Thanks, Ben. That's a great place to

leave it. Buy Ben's book. It's called Don't Fall For It. Amazon, go there and buy it. Thank you for watching and we'll see you next time.