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Snoopy's avatar

Why were so many taken in the Madoff hedge fund scandal?

Asked by Snoopy (5793points) December 16th, 2008

http://online.wsj.com/public/page/bernard-madoff.html

I am particularly interested in the psychology of what makes people make seemingly irrational financial decisions (i.e. no diversification).

Many individuals and non-profits had 90–100% of assets invested in this single fund, which apparently was a giant Ponzi scheme totaling 50+ Billion.

One thing that has been suggested is the exclusivity of participating in this fund. Not all who wanted to invest were welcomed. Hundreds were turned away.

Any references focusing on the psychology of investing would be appreciated.

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19 Answers

fireside's avatar

I just watched part 1 of The Century of Self that goes into a lot of detail about the origins of the materialist mindset that dominates our culture.

It talks about Freud’s nephew, Edward Bernays, who took Freud’s ideas about the subconscious mind and he spent his life developing ways to control people by positioning products or governments as “the thing to do.”

dalepetrie's avatar

People, at their core, are greedy. Even when they are cautious. Scammers wouldn’t exist if this weren’t the case, they exploit people’s natural greed. Most “smart” people can root out a scam pretty easily, because most scammers share a few traits.

1) They are unknown to you
2) What they claim is simply too good to be true

Neither of these was the case with Madoff, hence he made off with a lot of money (pun intended).

In terms of #1, first off, here were reasons people believed:

1) He’d been operating this LLC since 1960
2) He was known as a very philanthropic guy (people who steal are usually not also people who give away large sums of money, at least such is the stereotype)
3) He was instrumental in founding the NASDAQ and was its director for a time…if anyone would know about investments, it would be this guy
4) He had a LOT of very high profile clients who trusted him
5) He consistently returned profits to his investors.

So, he was very much a “known” commodity. And he fostered an image of being a discriminating investor by turning some potential investors down, creating an aura of exclusivity. Again, surely if he was just out to take people, he’d take EVERYONE for a ride, not just a select group.

Then there was the second part of this equation…too good to be true. Well

1) Again, he wasn’t taking on everyone, just certain people who met his criteria
2) The proof was in the pudding, he not only had an extensive client list, but he returned profits to them again and again
3) His returns weren’t eye-popping, just better than market….where a lot of Ponzi schemes fail is they offer too high a return and thus can’t be sustained as long…he kept his returns better than market, but only modestly better.

In the eyes of the person with money to invest, the ideal would often be to find an investment opportunity which was relatively stable over a long period of time, which returned better than average for similar funds, which had a long track record. And of course, investment opportunities like this where they DO exist, are not always all that easy to buy into. Well, this just seemed to many to be a cream of the crop kind of investment opporuntity, one that had proven itself time and again, and just like any once in a lifetime opportunity, if you were accepted, you might as well go in whole hog.

It’s like when you have a kid, you’re bound to get a postcard in the mail from some place saying they’ll make your kid a model. If you go to their offices, basically they’ll flatter you and make you think that your kid has opportunities, like maybe with a particular retailer or something along those lines…they’re not promising you that your kid will be the next great child actor, but maybe you can make enough money to put your kid through college by bringing him to photo shoots for Wal-Mart ads or what not. Then at the end, they say all you need is $500 to do some head shots, which they can do right there in their studio, but if you balk, suddenly it’s a now or never situation…they only have so much time to spend with each potential new client and they’re willing to take you on and take a chance on you, but you HAVE to give them that $500 TODAY…no you can’t think about it and call them tomorrow, by then they’ll have hired someone to take that spot, this is a once in a lifetime opportunity.

The idea is, hey, I’ve got this shot at something, and it’s not unrealistic, I mean other people do it all the time and make money, I’d be a FOOL NOT to do this when you get right down to it. Just THINK of how well this could work out for ME! And this is how it works. Whether you’re talking about giving a $500 check to some guy to take some pictures of your kid in an office that will have moved locations within the next 2 weeks, or whether it’s $500 million you’re getting the best possible return on that you’re lucky to have stumbled into, because not EVERYONE is this fortunate, and you’d be foolish to pass up this opportunity that worked so well for so many others.

wundayatta's avatar

Investment bubbles have happened many times in history. The classic one is the tulip bulb bubble in the Netherlands in 1637. People follow the herd, no matter how absurd or how foolish something is. If enough people do it, others pile on the bandwagon.

In this particular case, there was added prestige that made people feel more confident of the safet of the speculation, and the exclusivity meant they couldn’t question it. If they had an opportunity to get in, they had to get in.

As the article I referenced above says, ”How do investors avoid the doom of past mistakes? The answer is in the question itself – we become investors and not speculators.

Investors think. They make investments pass the smell test. Speculators jump on the latest trend, hoping to get out before the others do, and the speculation goes south.

SquirrelEStuff's avatar

@fireside

What a great documentary. You must watch the other 3 parts.

fireside's avatar

@chris – Definitely will. I have them ready and waiting.

Does anyone want to buy a piece of the Queensboro Bridge?
I’m only offering it to Flutherers and it will pay off big if Bloomberg starts charging for entering Manhattan.
PM me today and get your checkbook out, this is a very limited time offer.

steelmarket's avatar

Madoff is the financial equivalent of the serial killer. Ask the neighbors, and they all say, “He seemed like a great guy all these years”. Who would have guessed about all the bodies buried in the basement.

Snoopy's avatar

I also heard that the steroype investor in this type of scheme is a the widowed elderly woman w/ no family to look out for her….not true.

The prototypical person to make this mistake is a college educated, professional, male.

fireside's avatar

This was not the typical widowed investor by any means:

”...the victims in the UK were headlined by HSBC and the Royal Bank of Scotland, which is majority-owned by the British Government.

A charity set up by the Hollywood director Steven Spielberg was among those revealed to be among the victims, along with a foundation set up by Mort Zuckerman, one of the richest media and property magnates in the United States, dozens of Jewish organisations, sports team owners and a New Jersey senator.”

Source

dalepetrie's avatar

I heard on the radio today that one of the reasons a lot of Jewish charities invested their money with him was because he was considered as stable as a T-bill…by keeping a rate of return that was a few points higher than the T-bill consistently, he built up a reputation and was actually known in Jewish circles as the “Hebrew T-Bill”.

Snoopy's avatar

On Nightline last night they interviewed some people who lost out on the deal. They related consistent rates of return at about 10%, quarterly statements etc.

I suppose the more pressing question is how did this get past the SEC for so long?

The scheme was only revealed when he turned himself in…!

dalepetrie's avatar

Snoopy,

Actually what I read was two things.

One, he evaded the SEC by “liquidating” everything to cash just before quarterly reporting, and then moving it back in after the end of the quarter, which some people raised an eyebrow at, but no one apparently did anything about.

Two, he realized he was cooked, and said something to one of his sons about being “done”, and his SON turned him in.

Snoopy's avatar

Wow. Bet the holidays will be loads of fun at their house.

Mizuki's avatar

I guess investing with Madoff would have been the equivalent of investing in mutual funds in September of 2008, not too smart, blinded by greed, and too lazy to due diligence. All the writing was on the wall, but human nature makes folks too lazy to think critically.

Jeruba's avatar

Don’t you think we should vote to bail him out? I mean really. How is this truly different from the other investment guys and what they did? And we bailed them out. I thought it was amazing how quickly this chap was labeled a criminal when I was pretty sure we weren’t calling people that any more just for stealing billions of dollars from people in broad daylight. Instead we were covering their losses for them from our pockets. After all, who needs it more, a guy who owes $30,000 to Visa and MasterCard or a guy who owes $50 billion to the whole world?

Snoopy's avatar

More info revealed suggests that Madoff didn’t likely start the fund as a Ponzi scheme…..problems likely arose when there was a market downturn and his arrogance couldn’t admit that he could keep earning money. Cold comfort.

RE the SEC. Apparently credible reports of concern have been related to the SEC for a decade. Again, cold comfort, but at least someone recognized that something was wrong. Now….why didn’t the SEC act on those reports?

dalepetrie's avatar

The SEC is “launching an internal investigation”, which is code for “we didn’t do our fucking job and now we need to cover our asses.”

Snoopy's avatar

@dalepetrie. Yes…I would feel better if there were external investigators in the mix….

SquirrelEStuff's avatar

Like the external investigation of 9/11??

goober's avatar

MADOFF, MADE OFF!!!!!!!!!

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