“It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts,” said Sherlock Holmes in a book written more than 100 years ago. Even back then, Sir Arthur Conan Doyle had nailed one of the most important biases that causes humans to overlook fraud.

This bias, called the congruence bias, keeps us stubbornly tied to that first theory, says Pat Huddleston, a professional speaker, author and CEO of Investor's Watchdog LLC, a due diligence company that conducts investor fraud prevention investigations. And the older we are the more often it’s right, because we’ve seen more things, he said in a session in September at the ECOA conference in Las Vegas.

“We don’t like our first theory to be wrong,” said Huddleston. “As a result, we tend to accept facts that prove our first theory, and either reject, minimize or try to force facts if they don’t support that theory.”

Confirming Rather Than Investigating

He used this idea to explain why people lose millions of dollars to investment fraud schemes every year. “When you meet with a very well dressed, well spoken person, who says that they can help grow your money, and they’re describing a particular strategy and it all sounds very up and up, your first theory is that this person is who he or she says and the theory that they are proposing is legitimate,” said Huddleston. “The facts that flood in after that are going to tend to make you want to confirm that theory, which may or may not be true. This is particularly insidious,” he said.

Even when a person is skeptical, and attempts to do the due diligence for themselves, they often still fall prey to this bias, he said, because they are investigating to try to confirm that their theory is legitimate. “And because that is the theory you are trying to prove, you are going to accept the facts that prove it and minimize the facts that don’t.”

The 14^th Investor

Then he told the story of one investor who didn’t fall for the congruence bias and brought down a $400 million investment fraud. High-profile New York attorney Marc Drier sold fake promissory notes to 13 hedge funds. “Not 13 little old ladies, not 13 people who just fell off the turnip truck,” said Huddleston. This guy was very clever.

But the 14^th hedge fund manager thought something sounded fishy. When told that the Ontario Teacher’s Pension Plan was guaranteeing the investment, he was still unconvinced. Why would a huge pension plan want to do that?

Even after he spoke by telephone to Drier’s cohort who impersonated a pension plan representative, the fund manager continued to question the scheme and requested an in-person meeting in Toronto with the general counsel for the pension plan.

Drier (who had never met the fund manager in person) pulled off a daring impersonation of the general counsel at the pension plan office. And he would have gotten away with it, if the suspicious 14^th fund manager hadn’t asked that one last question of the receptionist: “Was that man I just met with the general counsel?”

“You will never find a fraud by looking for legitimacy,” said Huddleston. “You must look for fraud if you want to find a fraud. Assume people are lying – not with malice, but because it’s the only way to find out if they are.” In other words, be the 14^th investor.