Plenty of inexperienced traders lose their money to fraud schemes, but typically, in cases like Shkreli’s, the victims are investors who are “sophisticated”—meaning, in the words of the Securities and Exchange Commission (SEC), they “have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.” In other words, many of those who give their money to fraudsters are experienced enough that they should know the advertised promises can’t be true.
Take some of the so-called victims in the Shkreli securities fraud conviction. Many of them were not just experienced investors, but had an expertise in biotechnology, the field Shkreli was dealing in. Others were fund managers themselves. Moreover, most of these victims not only got their money back from Shkreli, but ended up multiplying their investment several times over (albeit thanks to profits earned from a separate endeavor of Shkreli’s).
Of course, these investors have every right to chase outsize risks as they please, and indeed some might argue that it’s human nature to seek out and believe in the possibility of enormous returns. But because of how markets work, overestimating what kinds of returns are feasible in markets that are roughly efficient can stoke demand for financial fraud.
Even better examples of implausible victims are those enveloped by Bernie Madoff's schemes. Most of them were part of highly sophisticated financial institutions and pools of funds tasked with choosing money managers on behalf of their clients. It is hard to believe these institutions fully trusted that a strategy that only invested in 30 to 40 of the largest companies in the S&P 100 would routinely provide monthly returns in excess of 15 percent.
The most powerful force on the demand side of the market for financial frauds is not individual investors but the professional managers who they appoint to manage their wealth; it is these investors who should know better.
As the 10th anniversary of the financial crisis approaches, it’s even more important that the narrative of financial fraud moves away from exclusively supply-side explanations. Take the much-demonized Collateralized Debt Obligations (CDOs), the structured financings that repackaged the risky mortgages at the heart of the financial crisis into highly-rated securities. Most narratives of the role of CDOs in the financial crisis emphasize the poor behavior of the homeowners who took on too much debt, or the banks that didn't exercise enough discretion in issuing home loans, or the investment banks that packaged up those transactions and sold them without enough disclosure, or the ratings agencies that ignored the risks inherent in those structured securities.
But CDOs wouldn't have thrived if there weren't buyers for them. Ultimately, it was insurance companies and other investors that demanded these highly rated notes with their enticing yields. And they were willing to suspend their disbelief about where that yield originated from as long as they could point to a high AAA rating when the investments went sour.