Why Investment Scams Work

The “Madoff twist”

How do Wall Street insiders, smart brokers, and big investors get caught by Ponzi schemes like Bernard Madoff’s?

According to John Kay in the Financial Times columnist, “the fraudster hints at impropriety, but implies that the target will be the beneficiary rather than the victim.” Kay calls this the “Madoff twist.” (FT 3/18/09 p. 9)

I doubt Madoff invented this twist. This kind of trap is set by a lot of unscrupulous people, whether or not they are actual “con men.” The idea is to sell the victim the idea: “we’re smarter than that poor dope.” This works by creating a sense of belonging, superiority, and being privileged to have inside information.

The “having inside information twist”

The “having inside-information twist” was noted by John Gapper, another Financial Times columnist, in his article” Wall Street insiders and fools’ gold.” (FT 12/18/08 p11). Mr Gapper was writing about Henry Blodget, a Wall Street analyst charged with issuing fraudulent research in 2003. Mr. Blodgett had an opinion about fellow con man, Madoff’s, scam.

Gapper summarizes Blodgett’s opinion:

Wall Street veterans thought Mr. Madoff was up to something. But he [Blodgett] adds, They did not think he [Madoff] was recycling client funds…they suspected that he was using inside information … to “front-run”* trades for his clients. [See my Note* below] That would have explained his oddly consistent high returns.

Blodgett’s reasoning about Madoff is an example of another way smart people get caught in scams.

The “human need for explanation twist”

This is a psychological mechanism everyone in the Bay Area knows, but we have no common name for it. During the Loma Prieta earthquake, Californians had thoughts like these.

“It’s sure windy on the bridge today.”
“Wow, I think I drank too much coffee”
“My tire must have blown out”

My own thought was that the BART train over my head was going off the tracks. I decided that was what was causing the cement columns around me to shake. Of course, while looking up to see where the train was, I had no explanation why the concrete under my feet felt like it was turning into jello.

Seconds later, all the car alarms underneath the BART station went off simultaneously. A passing cabbie yelled at me over the din, “Was that an earthquake?” I finally got what had really happened.

If we run into a new or rare experience, we explain it with whatever familiar idea seems reasonable. Somehow, I think humans need explanations, no matter how valid or invalid, to keep our primal fears at bay.

Unfortunately, our own good explanations are often what get us into trouble. Even con men get deceived by other con men because of our human tendency to make up explanations for new things using erroneous analogies with familiar old things.

Copyright © 2010 Nancy K. Humphreys

Note* Front-running is an illegal action by a broker when they buy or sell their own shares before filling their obligations to buy or sell the shares of their clients. That way the broker gains more or loses less money than clients whose transactions to buy or sell are put through later. Clients get burned when the front-running has caused the market price of a stock to rise or drop.