Thursday, 18 December 2008

Madoff Relied on ‘Irrational Euphoria’

They too offer inside knowledge in return for a fee and should be asked the same question that more people should have asked Mr. Madoff - if this scheme for making money is really so good, why sell it at all?

Why not simply use the technique to make money yourself?

1 comment:

Guanyu said...

Madoff Relied on ‘Irrational Euphoria’

By Kevin Connolly, BBC News
18 December 2008

If I had a dollar for every news story in which the golden rule of investment has been dusted off and repeated over the last five days, I would be able to pay back Bernie Madoff’s investors myself.

If something sounds too good to be true, I keep reading, that must be because it is too good to be true.

It is good advice as far as it goes and it raises the question of why so many wealthy, sophisticated savers were apparently conned into believing that Mr. Madoff had come up with an investment strategy that allowed him to pay handsome returns even when the stock market was falling.

I asked a very senior regulator about this, a man who has been involved in formulating public policy for many years, and he said the answer was depressingly simple.

People are prone to believe what they want to believe, he said, and in rising markets a kind of irrational euphoria takes hold in which we are not inclined to ask difficult questions.

Human psychology

The point about Bernie Madoff was not so much what he was selling, it was how he sold it.

On offer was a fairly standard hedge fund arrangement in which the Madoff firm bought stock in a company and then hedged against the risk by striking contracts to both buy and sell shares in the company at agreed dates in the future.

In the jargon of Wall Street that is a “collar”. It is perfectly legal, but it requires endless resources of luck, judgement, money and timing.

What made Mr. Madoff unusual was the manner in which he recruited his investors.

For that he relied on a powerful but elementary piece of human psychology: the more someone tells you that you cannot have something, the more you want it.

Membership of the Madoff fund was very strictly by invitation only - merely being rich was not enough in itself.

Clients were recruited through the social networks of which Mr. Madoff and his wife were themselves members - many were Jewish New Yorkers who spent part of the year in Florida.

Others came across the charming, wealthy, discreet giant of Wall Street at the golf club or the yachting marina.

The very respectability of the clientele helped with further recruitment.

Madoff customers were directors of charities and managers of investment funds as well as wealthy business people and pensioners.

They were mainly, in other words, people who should have known better and they fell for one of the oldest illusions in the book: that there is an inside track in the world of investment.

Mr. Madoff fed that illusion, and offered himself as the man who could offer you access to that magic, secret circle.

Too respectable

The giant bailout of the American financial system earlier this year introduced the concept of the bank that is “too big to fail”, in other words, is of such importance to the world’s financial system that governments decide that propping it up with public money is better than allowing it to suffer the consequences of its own greed or incompetence.

In his own way, Mr. Madoff was something similar - an investment adviser who was too respectable to scrutinise.

As former chairman of the Nasdaq stock exchange, Mr. Madoff was a huge figure on Wall Street - his thoughtful analysis of how modern regulatory systems made cheating virtually impossible has been one of the most-viewed clips on YouTube in the last few days.

The regulatory authorities, now that they have finally woken up, are now assessing how much of Mr. Madoff’s clients’ money has actually been lost and how much if any might be recovered.

The particular nature of the alleged fraud means, however, that existing clients seem to have been paid out of money taken from new customers as they joined the scheme. That probably means that if Mr. Madoff owes you money at the moment, the chances are that you will not be getting back.

It is not clear how many people working for Mr. Madoff knew what he was really up to with the funds collected from wealthy investors.

It has been widely reported that he operated this side of his business on a separate floor of the Manhattan skyscraper where his main company was based and it is even possible that he did not tell anyone else what was really going on until he explained it to his sons last week.

The court proceedings that grow out of all of this are likely to be complex and highly technical, but a friend of mine who works in the banking sector says the best way of understanding Mr. Madoff is to compare him to the kind of racing tipsters who advertise their services in the back of sporting newspapers.

They too offer inside knowledge in return for a fee and should be asked the same question that more people should have asked Mr. Madoff - if this scheme for making money is really so good, why sell it at all?

Why not simply use the technique to make money yourself?

I asked the regulator if the world would learn a lesson from the Madoff case and, depressingly, he was doubtful that it would.

These kind of schemes are only possible in a rising market and the next time the market is rising strongly - as it surely will one day - that old feeling of irrational euphoria will take over.

The reason we are easy to fool in the end, is because we are so good at fooling ourselves.