Why intelligent people fell for Bernie Madoff’s Ponzi scheme

The Ponzi scheme run by Bernard Madoff may have cost his investors some $50 billion. For many, the big question is how could seemingly sophisticated investors be so stupid? Even more important, what lessons can we learn from their mistakes so that we can avoid the next con artist who comes along?

Interviews with victims show that class status, exclusivity, reputation, blind trust, an unrealistic expectation for “safety,” and the old X Files “I want to believe” phenomenon contributed to their downfall. Those influences were apparently powerful enough to make investors go against common sense and ignore easy warning signs that all was not well with their money.

Madoff and other investment firms that hawked his fund took advantage of referrals within country clubs in Florida and networks in various Jewish communities. Investors were impressed that a friend or business acquaintance was doing well with Madoff and that made it easier for them to trust him with their money. The reports of good returns with low risk created a “feedback loop” of credibility for new investors.

There was also an air of exclusivity: hedge funds that invested with Madoff told their investors they were getting in on a wonderful opportunity available to selected investors. That “snob appeal” attracted investors who felt they deserved more than the average investor, who had to be content with retail mutual funds and ordinary stocks and bonds.

Some made their decisions based on the reputations of their professional referral sources, whether they were lawyers, investment advisors, or hedge fund managers.

Investors also may have had unrealistic expectations about returns and risk, and were willing to shut their eyes as long as reported returns were good. Madoff and his asset-gatherers didn’t tout large returns, but instead played on investors’ yearning for slow, steady returns that didn’t go down when the market dropped. “I wanted someone who was a little bit more conservative, someone who could let me sleep at night,” one investor told MSN Money. Some investors reported steady earnings over the years of 11 percent, year in and year out. That was just high enough to attract investors but apparently not high enough to strain credibility.

If a potential investment seems too good to be true, beware. If an investment offers a steady return of 11 percent at the same time that bank certificates of deposit offer 3 percent, something is wrong. Either risks of loss are not being revealed, or the investment is bogus. Think twice before putting money into a product that you can’t understand or lacks detailed written information on how and where money is invested. If there is documentation, make sure an independent third party can verify it for you. Stick with publicly-traded investments whose results can be obtained from sources other than your advisor.

Finally, don’t give money directly to an advisor. Your money should be held by an independent third party such as a brand-name brokerage or mutual fund. Those third parties should report your holdings, losses, and gains and their results should correspond with your advisor’s reports.