It is not about intelligence for those who fall for pyramid schemes

One and a half years after Kenyan pyramid scheme investors witnessed their entire savings sink in a flash, they can take consolation in the fate of their global peers who are apparently not better off.

As late as December last year, American investors were still putting their cash in Bernard L Madoff Investment Securities LLC, a Wall Street firm, until its chairman was charged the same month with perpetrating the largest investor fraud ever committed by a single individual.

With at least $50 billion (about Sh4 trillion) gone, Madoff’s scheme could be the largest investor swindle in history and one that makes our own pyramid schemes look like kindergarten stuff.

Closer home, victims of so-called pyramid schemes are still smarting from their losses, estimated at Sh20 billion from a total of about 160 schemes. And despite being heavy on promise, the Government is yet to convert rhetoric into action on the matter.

Local victims have formed an umbrella body called the National Pyramid Schemes Victims Initiative to try and regain their lost fortunes as suspected culprits continue to walk scot-free, while flaunting their ill-gotten wealth.

“Despite the losses, most of our victims are now more concerned about fighting social evil and impunity in this country than recovering the money,” said a philosophical NPSVI chief executive Joseph Kinyua during an interview at his office this week.

Legal entities

The association squarely blames the Government for their losses since the schemes operated as legal entities before being wound up.

But even as US and Kenyan investors fight for their rights with or without Government support, a huge mystery is why so many people broke a cardinal rule of investing by putting all their eggs in a single basket.

“When it comes to money and investing, investors are not always as rational as we think,” says Suntra investment Bank head of investment banking and fund management, Charles Ocholla.

The risk of over-allocating money in one position is what economists call lumpy risks. This is a dangerous over-investment in a certain sector or asset class, which means the value of your portfolio will go up and down in large swings based on the movements of the over-invested sector, he said.

According to him, behavioural finance attempts to understand and explain how human emotion influences investors in their decision-making.

“Faced with the prospect of selling a stock, investors become emotionally affected by the price at which they purchased the stock. So they avoid selling it as a way to avoid the regret of having made a bad investment as well as the embarrassment of reporting a loss,” he adds.

Several theories hold sway here. Regret theory comes into play for investors who find a stock they had considered buying but did not go up in value.

Some investors avoid the possibility of feeling this regret by following the conventional wisdom. They only buy the stocks that everyone else is buying.

Here, they rationalise their decision with the retort “everyone else is doing it”. That could explain how investors jumped on to the pyramid band wagon, some after being egged on by the religious folk and men of the cloth.

But still, why would an individual commit his entire savings in a single entity? According to prospect/loss-aversion theory, people prefer a sure investment return to an uncertain one.

That is pretty reasonable. But a strange part is that the prospect theory suggests people express a different degree of emotion towards gains than towards losses.

“Individuals are more stressed by prospective losses than they are happy from equal gains,” says Mr Ocholla. The theory also explains why investors hold onto losing stocks; people often take more risks to avoid losses than to realise gains.

Just like in Kenya, Michael S. Rosenwald wrote in Washington Post early this week that many investors — charities, individual investors, even well-known fund managers — have lost everything, right down to their last penny.

How could so many smart people do something that, in hindsight, seems so dim-witted? The answer is simple. No matter how accomplished, experienced or savvy, people succumb to age-old human behaviours — and failings — when making investment decisions.

Take Mr Eliud Thuku, for instance. He resigned from a teaching job in 2006 at the height of the pyramid craze and opted to put his entire Sh330,000 savings in three schemes.

“I was earning a good interest totalling Sh18,000 per month and decided to feed on that as I searched for what to do,” says Mr Thuku who had only received three months interest when disaster struck.

In over-allocating money to one position, investors are typically prone to several short cuts that get them in trouble. One primary mistake is uniquely intertwined with Madoff’s alleged scheme — the allure of small but consistent gains.

Similarly, a chart of Madoff’s purported returns shows a line going steadily up, month after month, one or two per cent. Those kinds of gains are intoxicating.

Both scenarios also exposed a persistent problem among all investors: failure to do timely re-balancing of their portfolios.

An Alliance Bernstein survey of 1,000 investors showed that nearly 40 per cent of investors without an adviser did not have an approach for allocating and re-balancing investments.

Some 55 per cent of those people reported that they never got around to doing it. Mr Ocholla puts it this way: “Too much of any one type of investment is risky. It is important to note that diversification is not achieved by having lots of different types of equities or different types of bonds or any other asset class.

Trusting nature

Instead, diversification is achieved by a prudent mixture of non-correlating asset types, which means you generally need at least all three - bonds, equities and properties along with other funds.”

Investors - as both Madoff and our pyramid schemes indicate - can become prey to their own trusting nature.

Mr Rosenbald wrote that many investors were led to Madoff by similar connections in Jewish social and philanthropic circles in what he called affinity investing — investors let their guard down and are liable to break investment rules when they are led to the water by someone they trust.

The Kenyan connection is that investors here were taken down the drain by respected religious leaders many of whom were part-owners in the schemes. Others received commissions for the “flock” delivered to the scheme.

“Ask the investors how many of them got into the schemes through their pastors’ persistence and encouragement and you will be shocked,” said Mr Kinyua.