Let’s say you are investing money in something, what is the rate you want to be scammed?
You could, of course, say that rate should be zero. That you will tolerate no loss due to scams, unethical practices, etc. But that puts an extreme due diligence burden on you before you make an investment. You can’t be 100% on BOTH precision and recall. If you have fewer false positives, you will inevitably have fewer false negatives.
Being skeptical of everything will allow you to avoid investing with Madoff, but it will also have you miss that angel investment in Facebook and Airbnb. Many ideas seem very crazy (until they aren’t).
This is also true in life.
You can distrust every taxi driver and every construction contractor … but that might lead do you distrusting most people which could lead to a lot of unhappiness.
Or … or … or … you can accept that you will have some rate that you will be scammed.
You should have a rate you want to be scammed.
A good rate is likely 1-3% of your interactions. This can be on taxi cab drivers, investments, hires, etc. If your scam rate is under 1%, you are likely not taking enough chances. If your scam rate starts approaching 10%, you might lose all your money.
If you never get into a car, you will never die in an auto accident. But you will also have a lot of trouble living life. So you need to have some guide-rails (wear a seat belt, don’t get in a car with a drunk (or sleepy) driver, etc.). The same is true for investing or doing anything else in life.
Retail stores as a model.
Retail stores have figured this out. They know that people will steal things from them. Customers will steal things. Employees will steal things. Customers will abuse return policy (like people getting the big screen TV the day before the Superbowl and returning it the day after).
Retail stores factor in shrinkage. They assume it will happen. Maybe they assume its 2%. They are essentially assuming a 2% scam rate. And yes, they COULD get that rate much closer to zero — but that comes at a large cost. They could make sure that employees don’t steal from them — but that means they need added surveillance, more bureaucracy, and they need distrust the good employees (which are the vast majority of the people that work for them). The same is true for getting the customer shrinkage rate to zero — efforts to do that might inconvenience the good customers (which are the vast majority of people that buy from them).
Retailers could ensure that customers do not take advantage of them. But allowing for a liberal return policy also increases sales.
Retailers could ensure that items cannot be stolen from the store … but tagging all the items comes at a cost … and customers don’t like to be frisked when leaving.
So instead retailers target a shrinkage rate. If the shrinkage rate gets too high, they are losing money. BUT … and this is the most important sentence of this post … if the shrinkage rate gets too low, retailers also lose money. If the shrinkage rate was 0.2% rather than 2%, it means they are optimizing for fraud protection rather than revenue growth.
The same thing is true in investing.
If you never get scammed, you are likely not taking enough risks.
Of course, if you get scammed too much, then you are also in trouble.
For instance, let’s look at bitcoin. A lot of people think it is a scam with prices pumped up by wash trading. (I don’t personally have an opinion on it). But it would certainly not be responsible to put a massive amount of your investing capital in Bitcoin — whether it is a scam or not, it is a very risky asset that has the potential to go to zero.
But if you have been a professional investor in the last 10 years and you invested $0 in bitcoin, that also might not be great (especially if you took the time to do the work on it). The important thing is that if the price of bitcoin goes to $0 or your bitcoin gets stolen by a hacker (both of which have high probabilities), how will that affect your life? If 30% of your net worth is in bitcoin, then you’ll be hurt a lot more than if it was 1%.
We will all be scammed … a lot.
If you think you are not being scammed, you are just ignorant. Everyone gets scammed. Scams happen to all of us. And they happen a lot. Sometimes they are big scams. Sometimes they are small scams. But we all get scammed.
The simple thing to remember in investing is that you will be scammed. It will happen. The more you invest, the more you will be scammed. The more people you interact with, the more you will get scammed. The more you do, the more you will be scammed. Walmart gets scammed a lot more than the local corner store because WalMart has a lot more customers.
The problem isn’t that someone was so stupid to put their money with Madoff. That can (and will) happen to everyone. The problem is that some people put ALL their money with Madoff.
If you put 2% of your assets with Madoff and found out it was a Ponzi scheme you’d be super bummed but you would survive. If you put 50% of your assets with Madoff, you are in deep trouble.
If you have to make a very large investment, then you need to do massively more due diligence. For instance, you do NOT want to get scammed by someone you marry. In the case of marriage, you want to have an extremely high likelihood of success. Summation: do a LOT of due diligence on a potential spouse.
Beware of the macro-scam.
One of the tough things with investing and scams is that many investments are highly correlated with each other. For instance, you might believe that the entire last ten years is a bubble propped up by the scam of quantitative easing. If that is the case, many of one’s investments (from stocks, bonds, real estate, etc.) could come crashing down. So if the scam is a meta scam (i.e. bubble) then you might have a much higher percentage of your assets vulnerable if the scam is eventually uncovered (the bubble pops). Summation: it is significantly harder to avoid macro scams than micro scams.
Advice on what do to after being scammed.
When you do get scammed, here are a three pieces of advice:
1. Move on. Don’t stew on it, just move it. Salvage what you can (and take the tax write off).
2. Warn everyone you know. If you were scammed by somebody or something, you have a moral duty to warn everyone you know. If it was a person, you have the duty to tell the authorities and to do everything possible to significantly reduce the scammer’s reputation so that they are not in a position to scam others again. Just walking away is immoral (in my opinion) because it means the number of victims will increase.
3. Never, ever, interact with this person again. “Fool me once, shame on you. Fool me twice, shame on me.” If you are scammed by a person, never let them back into your life for any reason ever again. Yes, people do change and people do get reformed … but the psychological impact of getting scammed twice is too great to take the risk. That does not mean you cannot eventually forgive the scammer. You can forgive (I have tried, and failed, to forgive). But even if you forgive, it does not mean you need to interact with the person.
What is the rate that scams should take place in society?
Maybe a better question is what is the ideal rate of corruption in society? What is the crime rate? It is not zero. Zero would require the panopticon looking over you and watching your every move.
Again, likely an ideal society scam rate is in the 1-3% range. Where 1-3% of your interactions are scams. Most taxi rides are above-board. But a few taxi drivers are figuratively going to take you for a ride. If you are taking a taxi in Beirut, the number might be more like 80% which can be incredibly frustrating as every ride becomes and a negotiation. If it is closer to 1% (or maybe as high as 5%), then you can be more relaxed.
Certain industries are more likely going to take people for a ride than others. Those industries are generally ones where there are highly unscrupulous people that go into them (illegal drug dealers) or ones that have high information asymmetry (healthcare, construction, etc.).
What do you do if the decision IS really important?
What do you do if you or a loved one get a serious disease? You don’t want to be scammed by the system. This is the case that makes sense for you to do lots of research on every provider. Don’t just take someone’s recommendation. Do lots of reference checks on people. Ask very probing questions. If you can afford it, hire a private investigator. If you can afford it, hire an advocate.
Anyone that has actually gone through life accepting a scam rate has saved up thousands of hours over the years. This is your chance to deploy those time savings to make sure you make the right decision.
Summation: have an internal base rate that you want to be scammed.