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April 10, 2009

Financial frauds-3: Introducing Bernie Madoff

(For previous posts in this series, see here.)

Bernard Madoff has reportedly swindled investors out of $50 billion of their money. You might have noticed that news stories repeatedly emphasize their surprise that the people who were defrauded were 'smart' people. If you look at the stories more closely, you will find that they do not really specify what they mean by smart. What they point to is that they had a lot of money, lived well, moved in exclusive circles, and attended elite schools. These are the measures that most people use to determine whether someone is 'smart' or not. It seems to be a basic assumption that rich people who have had extensive formal education at elite institutions cannot, by definition, be fools. Hence they must be 'smart'.

But there is a difference between being merely conventionally 'smart' as determined by these measures and being genuinely smart. The biggest suckers are those who have convinced themselves that they are smart but really are not.

I once watched the magician James Randi give a demonstration of his tricks to a group of physicists and he completely bamboozled them. He said that it is really easy to fool people, and the more well educated people are, the more confident such people are of their own cleverness, the easier it is for magicians and other tricksters to take advantage of them.

Madoff seemed to have taken advantage of four psychological weaknesses that such conventionally smart people tend to have. The first is that he provided attractive and steady returns on their investments, but nothing spectacular. 'Smart' people are suspicious of get-rich-quick, something-for-nothing schemes, rightly suspecting that those must be frauds. But here was someone who was providing a slightly above average rate of return of about 10% on investments when the stock market was going up, and still managing to provide good returns when the market was going down. So he was definitely outperforming the market but not by amounts that might make people too suspicious. It seemed plausible that he had some kind of system, although he never said exactly what he was doing that enabled him to be so steady, claiming that doing so would reveal his business secrets.

The second was that he was well-connected, a friend of the elite, a former chair of the NASDAQ stock exchange, a public benefactor. He was a member of the exclusive Palm Beach Country Club where he played golf with many of the people who eagerly sought him out to invest their money. They felt he was one of them, their friend. People tend to trust members of their own class, their own social circle.

Third, he played hard to get so that people were made to feel that he was doing them a favor by taking them on as clients. People sought him out, tried to get their friends to recommend them to him as clients, and sought to curry his favor. And he would turn money and people away, thus increasing his appeal. When people have irrationally set their hearts on achieving a goal, they do not pay attention to the normal warning signs that govern their other actions. (Woody Allen riffs on Madoff's technique and his victims.)

Fourth, and perhaps most significant, was that he gave people a wink and a nudge that the system he was using was perhaps not quite legitimate, that he was skating close to the edge and using insider knowledge that may have come with being former chair of NASDAQ, and that other people, those ignorant poor saps, were being exploited in order to give them their returns. So those who invested with Madoff felt that they were also financial players, that they were on the same side as him, making money at the expense of suckers like you and me.

These very rich people have no problem with people who take money from those less well off, since they often do so themselves, both legally and illegally. That comes naturally to them. What they found shocking was when it was revealed that Madoff's targets were themselves. Madoff was playing a classic con game, taking advantage of rich and greedy people's willingness to take unfair advantage of people poorer than themselves.

It is the same psychology that was used by the small-time conman to lure the big-time gangster into the con in the classic film The Sting. If you have never seen this Paul Newman-Robert Redford film, you have missed a treat. Here is the classic poker scene from it.

Next: How Madoff ran his scam.

POST SCRIPT: What we need is more sports!

The Onion News Network reports on plans to expand the NCAA playoffs to 4096 teams.

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Comments

I'm not sure if I'm happy or not about the NCAA team expansion, I guess it means more games either way though.

Posted by pink chi iron on April 12, 2009 01:14 PM

im just thankful madoff didn't hit the Philippine Stock Exchange.

Posted by Philippine Stock Exchange on October 23, 2009 08:55 AM