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Madoff’s fraud; As long as there are passive investors there will be victims December 27, 2008

Posted by shaferfinancial in Uncategorized.
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With all the attention given this ponzi scheme, let us dissect the scheme from the point of view of psychology.  Even though the media is making a big point of saying there were clues the victims could have discerned over the last 10 years to this fraud, this is nonsense if you know a little something about psychology.

There are four psychological factors that play into this unfortunate scene.  First, as I pointed out earlier this week is value attribution.  Madoff had this in spades.  A fancy NY City office, Palm Beach residence, the right clothes, the right friends, Palm Beach Country Club, a long history on Wall Street and connections to the biggest and best Jewish philanthropic organizations.  His upper middle class and upper class victims look to all these things as “prima facie” evidence of success, gravitas, and uprightness.  Now remember these psychological factors are present in everyone without exception, it is the way we limit the information to a manageable amount.  So we all judge people this way, providing trust to folks who appear to have the values we prize. 

The next critical psychological process is loss aversion.  This is perhaps the most ingenious part of the fraud.  Unlike the original Ponzi scheme, he didn’t promise or demonstrate huge returns, instead he showed consistent high single figure and low double figure returns.  Never a loss.  As I have pointed out before, losses for passive investors trigger loss aversion activity like redemptions of funds.  With only small amount of people asking for their money back, the fraud could continue unabated for years.    By not giving anyone a psychological reason (with a reported loss) to redeem their money he kept the scheme going for years.  And when the newspaper headlines started to really scare people and they started to redeem their shares, the whole ponzi scheme collapsed.

Next is momentum or commitment.  We have a tendency to keep doing what we have been doing, despite any evidence of its efficacy.  Some people describe this effect as bad habits, but it is really much more deeply seated than just a bad habit.  Human beings have the ability to ignore all evidence that contradicts there way of doing things, no matter how bad the outcomes are.  Criminals keep committing crimes even after being locked up and dragged through the system,  investors keep investing in mutual funds even after poor returns,  we keep overeating even after gaining weight; the examples are endless.

Finally, is the chameleon effect or mimicking.  We have a tendency to mimic the behavior of folks.  This is the key to marketing, getting people to simply copy others in using a product or service.  Madoff became the one to invest  money with in the Jewish world.  Folks started mimicking others and the rest is history.

Even some, the media has dubbed “sophisticated investors,” lost money in this scheme.  However, the point the media is missing is that all the victims were “passive” investors because Madoff didn’t reveal to his investors how he was making money.  Only a passive investor would put up with this, active investors demand to know exactly how money is being made.   This is the key point for me, of course.  The truth is that this fraud is based on exactly what Wall Street is based on.  Not that all of Wall Street is a fraud or ponzi scheme, it isn’t, just that the environment of Wall Street uses the exact same psychological processes that Madoff did to get people to hand them their money to invest.  And those are exactly the reasons I founded the Shafer Wealth Academy to help people see through those psychological processes in order to improve their investing results.  Data has demonstrated that the only way to break through these psychological processes is to have a “blocker” or a “gadfly” that will openly question and/or point to the actual data.  Of course this only works if you create the environment of an open team approach to decision making.

When I suggest the need to become an active investor, part of the process is having either a formal or an informal group of folks that will question decisions or at least a group of folks that will openly discuss investment decisions.  The person who goes it alone, will always be susceptible to the above psychological processes, while the active investor that has a team of folks to bounce ideas off, will at least have in place the correct environment for avoiding decisions being totally dominated by psychological factors.

Going into the new year, consider putting me on your team.  Consider joining the academy at some level.  Going it alone leaves you susceptible to your own psyche.  Put a gadfly on your team!

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