The Investment Scientist

How Madoff did it

Posted on: July 3, 2009

This week, Bernie Madoff was sentenced to 150 years in prison by New York District Judge, Denny Chin. With the trial now over, Madoff’s victims are still fighting over what little is left of his fund. They want to know: Where was the SEC?

More appropriate questions should be: How did Madoff do it? What human frailties did he exploit? How was he able to con $65 billion out of the most sophisticated members of our society?  Here’s how his scam worked:

Affinity

We humans lower our guard when we believe other people are similar to us. Madoff exploited this one masterfully. Much like Charles Ponzi, who looked for his prey among Italians, Bernie Madoff focused on exclusive Jewish social clubs and Jewish foundations.

Social affirmation

We rely on social affirmation when assessing a person we don’t know. This is why celebrities carry extraordinary persuasive power. Madoff became known as a philanthropist. He served on the boards of non-profit foundations. Many of them ended up investing with him. His philanthropic activities allowed him to bag clients like Elie Wiesel and Steven Spielberg. Much like Jordan affirms Nike, Madoff used the names of these righteous and talented people to gain credibility.

Authority

One Madoff victim, a CPA, said: “If I had just dug a little, I would have uncovered the scam; but there is no reason for me to dig – he is the chairman of Nasdaq.” We humans are known to defer judgment to authority. Madoff was an expert at creating an impressive aura of authority. (How did he get to be the chairman of Nasdaq? What does that say about the financial industry? Read Charles Green’s eloquent essay here.)

Scarcity

According to one report, a NYC real estate investor literally begged Madoff to take her money: he refused. When stories like this spread, prudence gets thrown out the window.

How to avoid being “made off”

Keep a healthy dose of skepticism. The fact that Madoff kept personal custody of client assets should have rung an alarm bell.

Take your time to do due diligence. A phone call would have uncovered Madoff’s accounting firm was just a hole in the wall.

Demand total transparency. Never, never, never invest in a “black box”, even if it is supposed to generate fabulous returns.

Need help with investment? Call 301-452-4220.

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3 Responses to "How Madoff did it"

Michael,

I just had a post on my blog http://www.inside1031.com on how to spot a ponzi scheme, but I like your article’s approach on the thought process of the investors who lose rational focus when under the influence of these forces…

How did he do it? Simple–he lied. And people believed his lies, because they wanted to believe that making money is simple and investing generates consistent returns. Well, it doesn’t, and you should never invest (or give your money to someone else to invest for you) if you haven’t done your research. My company, Hawkly Financial, helps you do just that. Try it out, if you don’t like it, don’t worry, you can keep your billions!

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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