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1 September 2017 CFA Institute Journal Review

Investment Professionals’ Ability to Detect Deception: Accuracy, Bias and Metacognitive Realism (Digest Summary)

  1. Sandra Krueger, CFA
The failure of investment professionals to detect deception can result in losses for investors. Unfortunately, analysts tend to be overconfident that they can detect deception and to largely believe financial statements. Because most fraudulent activity escapes the notice of auditors, the pressure is on financial analysts to judge the truthfulness of executive statements.

What’s Inside?

Investment professionals share the widespread belief that liars betray themselves through nervousness and gaze aversion. But only a small number of behaviors appear to be related to deception. Cues to detect deception are difficult to discover because behavioral differences between liars and truth tellers are tiny. A comprehensive analysis of the deception literature finds that liars are less cooperative and their stories less convincing. Unfortunately, these cues have only a weak connection with deception.

Investment professionals are overconfident, believing that they can accurately detect deception more than 65% of the time. But research has shown an average accuracy rate of 54%. This rate remains consistent even among professionals who make judgments as part of their job and amid changing circumstances.

How Is This Research Useful to Practitioners?

Investment professionals’ trust in financial statements leads to a very low accuracy rate for detecting deception. Investment professionals may have limited insight, which makes it hard for them to know when they should act on their judgments of deception. Rather than relying on one source of information, analysts may be better off using the mosaic theory to glean information from as many sources as possible.

The authors’ findings would be useful to investors in highly concentrated portfolios, where overconfidence in a single stock can result in large losses. Because fraudulent financial results may escape the notice of a firm’s auditors and analysts, the authors indirectly make a case for broad diversification.

How Did the Authors Conduct This Research?

Financial professionals were presented with three sets of videos and several conference call recordings owned by Bloomberg. They were then asked to determine the truthfulness of each one. The videos were provided by authors of deception detection research. The first set of videos was based on interviews with mock terrorism suspects. The second set dealt with a mock crime, and the third set involved high-stakes lies regarding the disappearance of a loved one. The conference call recordings featured such companies as Office Depot, Hansen Medical, and IndyMac Bancorp before they were exposed as having withheld information, an action resulting in SEC enforcement actions.

When participants were asked to judge whether corporate executives were telling the truth or lying, they made a correct judgment only 51.8% of the time when evaluating finance statements. Neither age nor confidence was related to judgment accuracy. Regardless of participants’ confidence, accuracy was poor. At a very high confidence level, participants’ judgments were significantly worse than guessing: Only 33% of their judgments were correct.

Abstractor’s Viewpoint

Investment analysts’ inability to depend on their lie detection ability is not good news for the profession. The overconfidence of analysts who believe they have skills to detect deception can ultimately result in investor losses. Because overconfident people are perceived as having higher social status, it is not surprising that overconfidence bias is present among analysts. The training of analysts should include required readings on this topic, because awareness might help lessen the bias.

Additional research could be done with groups of auditors to ascertain why they fail to detect fraud. It would be interesting to learn the extent to which time or budget constraints affect auditors’ willingness to accept discrepancies or suspicious documentation.

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