Remembering Bernie Madoff

Charles Ponzi.

Source: Jared Enos/CreativeCommons

On the morning of April 14th, Bernard L. Madoff, the orchestrator of the most expensive Ponzi scheme in history, died at the age of 82 after serving 12 years of his 150-year sentence in federal prison. As the greatest disgrace in investing history, it is hard to imagine any tears were shed among Madoff’s victims at the news of his death—I’m sure they wish they had never so much as heard of Bernard Madoff. Although most would surely prefer to forget him, there are some major downsides to Madoff’s story fading into history. The downsides are that Madoff remains the very best reminder that anyone can be duped by a con and the false beliefs that cons introduce to others can persist no matter how much evidence there is to disconfirm those beliefs.

Indeed, there are lessons to retain from Madoff’s story. Madoff was also the best reminder that anyone can run a successful Ponzi scheme. It really wasn’t wizardry and persuasion that enabled Madoff to get investors—over 4,800 of them who invested a combined $18 million—to invest in his hedge funds. Although he was well-known and highly respected on Wall Street, most investors never so much as met Madoff, much less spoke with him. As long as you can promote the façade that you know what you are talking about and invite people to keep their money “working” for them, you can run a successful Ponzi scheme—which won’t be difficult as long as you can give investors back 10% of their cash, pretending it’s real profit on their investments.

What is impressive is that Madoff was able to snow investors and US Securities and Exchange Commission (SEC) investigators for so many years (from 1991 to 2008). Madoff’s scheme began to deteriorate in 2008 once investors requested a total of $7 billion back in returns when he only had $300 million left in the bank to give back. Still, it does not take wizard-level influence skills to generate nonsensical explanations for performance growth and to persuade masses of people to give you large sums of money when you can demonstrate—at least temporarily—that you can capitalize on their investments.

Why Investors Believed Madoff's Lies

Social psychological research on bullsh*t detection suggests that Madoff succeeded primarily due to the way people tend to respond mentally and emotionally to bullsh*t and lies, neglecting the all-important value of genuine evidence. If only investors hadn’t been so bullible. People are bullible to the extent they fail to recognize something is bullsh*t even when there are cues present that would otherwise signal that it is bullsh*t.

One of the reasons people are so bullible today is that the pace of life is faster than it’s ever been. We’re no longer patient for truth and appropriately validated discovery. We want answers and quick-fix solutions to problems now. Sure, the glacial speeds of scientific investigation and due diligence are far out-paced by our desires to have or feel a subjective sense of knowledge. But that doesn’t mean we will do well in the ways of rational judgment and decision-making to believe in nonsense that just happens to sound good.

The most diagnostic cue to bullsh*t is that when you really investigate a claim, you find there really are no good reasons for believing it. The best nonsense Madoff used to account for his hedge fund’s achievements was that he employed a “split-strike conversion strategy.” This allegedly involved purchasing a combination of blue-chip stock shares within the S&P 100 and 500 and then insuring them with put options that gave him the right to sell assets at a specified price by a specified date. In this way, Madoff could hide the footprints of his “stock trades.” The sort of strategy Madoff allegedly used would have left a huge paper trail—but when there is no paper trail for stock trades, there really is not any evidence for a Ponzi schemer’s claims. Worse yet, although Madoff was very visible as a broker, he didn’t even list his hedge funds anywhere nor make himself known as the manager. There was no evidence other than Madoff’s word. If only investors had done well by remembering Hitchens’ razor: That which can be asserted without evidence can also be dismissed without evidence. The burden of proof for the truthfulness of a claim lies with the one who makes it. If the burden is not met, the claim is unfounded, and its opponents need not argue further to dismiss it.

Securities industry executive and forensic accountant, Harry Markopolos, took the dismissal even further because he wasn’t buying any of Madoff’s claims. By running a simple plausibility test, Markopolos could see that Madoff’s alleged strategy made no sense. Madoff reported steady returns of 1% a month, with a consistent, average return of 12% a year, no matter how the S&P 100 and 500 indices moved up or down—all the while, claiming that his returns were market-driven. Yet, it is nearly impossible to make market-driven decisions, all within the S&P 100 and 500s, when one’s performance corresponds to only 6% of the market fluctuations for 18 years. This should have been blatantly obvious to anyone watching the indices and Madoff’s reports.

Markopolos also reasoned that one could realistically purchase only $1 billion of “put options” for blue-chip stocks. At various times, Madoff would have needed more than $50 billion of these options to protect his investments—far more than existed in the system. Although Markopolos alerted the SEC three different times, no one would listen to him. After all, no one really wants to believe their investments are tied up in a Ponzi scheme, much less look at the basic statistics, especially when they appear to be making 12% returns on investments annually. Thanks to Madoff, we are aware of a few more Ponzi scheme red flags—they’ll be worth it not to forget.