The Ponzi Dilemma
How would the average investor know that
Bernie Madoff was running a Ponzi scheme?
Here’s a supreme irony for you. About six months ago a colleague of mine named Stephen Greenspan, a psychiatry professor at the University of Colorado, sent me a book manuscript to review and blurb for him (a blurb is one of those back jacket endorsements from someone who hopefully knows something about the subject of the book). Greenspan’s book is called Annals of Gullibility (Praeger, 2009, due out in January), and it includes chapters on gullibility in literature and folktales (Pinocchio, Gulliver), in religion (end-of-the-world predictions), in war and politics (the Trojan Horse), in criminal justice (child witnesses), in science (cold fusion), and in finance (Ponzi schemes). It’s a great read and an excellent reference source that, as I wrote in my blurb, “belongs on the bookshelves of skeptics and scientists, not to mention politicians and policy analysts, especially before they go to war.”
Well, last week Stephen emailed me a query letter about writing an article for Skeptic on Ponzi schemes, based on the chapter in his book, and — here’s the irony — it would recount how he lost a huge chunk of his retirement investments (to the tune of hundreds of thousands of dollars) not to the market collapse (like the rest of us) but by investing in none other than Bernard Madoff’s now-infamous Ponzi scheme. Yup, a psychiatrist who wrote the book on gullibility got taken.
What I am skeptical about here, however, is not Madoff and his scam, but the media’s portrayal of his investors as suckers for falling for it. My question is this: how was anyone outside of the Security and Exchange Commission (SEC) to know? What signs and signals were there for the average investor to see? Madoff was head of NASDAQ for three years and his investment company apparently consistently returned annual dividends to his investors in the range of 8% to 14% — healthy but not outrageous (apparently his golf scores were similarly rigged to make him appear good but not great, shooting 80–89 every round). One could make the case that the SEC should have known (indeed, they were warned in 2005 that Madoff was running a Ponzi scheme), or that investment experts who monitor the business should have been suspicious (and some of them were but their voices went unheard). But how would a college professor in Colorado, or Joe the Plumber in Puckerbrush, Pennsylvania, or you and me as Joe Sixpack investors know that Bernie Madoff was a latter-day Charles Ponzi?
Madoff’s deal was especially effective because it was what is called an affinity scam, where you appeal to those in your social group, in this case Jewish investors. It makes you feel like you’re an insider, a member of an exclusive club, and as such you would surely not be scammed by one of your own. If, say, you were working in the entertainment industry and Stephen Spielberg or Jeffery Katzenberg (both clients of Madoff) phoned to tell you about this sound investment opportunity that was by invitation only and that they could get you in for a minimum of $100,000, and that they had been invested for years in this program and had reliably received annual dividend checks ranging from 8% to 14% on their money, what would you do? You’d most likely jump at the opportunity. In fact, in his article in the forthcoming issue of Skeptic (and in this week’s eSkeptic), Stephen Greenspan recalls that he felt like he would have been a fool not to capitalize on this opportunity. Was he a fool for so doing? Only in hindsight. But what foresight was there?
By way of analogy, in 2000 I co-hosted a television series for the Fox Family Channel called Exploring the Unknown, in which we produced a segment on cons and scams, one of which was the infamous three-card monte. We employed the help of a professional magician named Dan Harlan who set up a cardboard box at a street mall in Santa Monica to show us how easy it is to sucker people into giving him their money (watch the segment on YouTube). It’s a relatively simple game. There are three cards on top of the box. One of them is, say, the Queen of Spades (the money card), while the other two are numbered cards. Your task is to follow the Queen as the magician/conman rapidly moves the cards around the boxtop. When he is finished with half a dozen moves, you place your bill ($5, $10, or $20) in front of the card that you think is the Queen. If you are right he matches your bill. If you are wrong he takes your bill. Unless you are a shill working for the magician/conman (who is signaled through an agree-upon sign where the Queen is located so that he can occasionally win), you will always lose. Why? Because the three-card monte involves one sleight-of-hand move whereby when he is rapidly moving the cards about and occasionally showing you the Queen on the bottom of two cards in his hand, he moves his ring (or pinky) finger down a card from holding the top card to holding the Queen, so that when he appears to be tossing the bottom card (Queen) onto the box top, he is actually tossing down the top card and thereby moving the queen to a different spot. You can’t see it. For the show we had to ask Dan to make the move in slow motion for us, and even then we had to slow down the tape in order to see the move.
Would you be fool enough to fall for the three-card monte? Most of us would say no, because we have heard that it’s a con, or we’ve seen shows like the one I produced, or we’ve read about it in a magazine or a book. But if you had never heard of the game and saw one being played, by the information of your senses you would see some people winning (you wouldn’t know that these are shills) and you would not see the sleight-of-hand move. So it would not be unreasonable to believe that you stand a reasonable chance of winning. In other words, what signs would there be that a con was underway?
The analogy holds for Madoff-level investment scams. Short of just being skeptical of all investment technologies (which, obviously, most of us are not and that’s what helps fuel the modern economy), how are any of us to know which investment companies are legit and which are not? The SEC? We’ve seen how well that works, so what’s an investor to do?
My answer is … diversify. What’s your answer?
Actually, the SEC were first warned about Madoff in 1999 by an accountant, Harry Markopolos, who reported Madoff again in 2005. The SEC basically let him off.
Source: http://www.independent.co.uk/news/business/news/wall-street-insiders-had-shunned-madoff-for-years-1203850.html
I’d like to say if the SEC was free to do its job, he would have been caught.
Unfortunately for that glib yet fully accurate answer, I believe Bernie was running a hedge fund. Hedges are a) unregulated and, unless things have changed, b) only open to those wealthy enough to lose sums invested in hedges.
Really, this whole “belief” pushed by the speculator class and the current administration is offensive: If wealthy investors’ speculative investments tank, the gummint should make them whole again. As opposed to the victims of damage to the economy caused by the wild speculation. (And this point, I will *not* reference the silliness about autoworkers having to bail out GM and Chrysler by giving up parts of their salaries which are, in the first place, insignificantly higher than non-union workers’.)
Haven’t heard of a Madoff victim that’s triggered my compassion. Any of them renedered homeless or foodless or jobless as a result (exclusive of Bernie’s employees of course, who were enablers, abetters and, oh yeah, accomplices in the scheme — hey, which of them blew the whistle?).
My answer is … diversify. What’s your answer?
Buy a large mattress (or in my case a smallish one) and put your money under it – over the next year or two with a reasonable prospect of deflation its value may go up!
In this case, it was possible to demonstrate statistically that Madoff probably couldn’t have achieved the returns he was claiming he was making by doing what he said he was doing.
So at the very least he was probably lying about what he was doing.
Investing large sums of money with a person who is probably lying about their activities is probably going to be painful.
It appears that Madoff and at least one colleague not only generated false monthly statements but even created fraudulent trading tickets for illusory derivative trades to show the few investors who pressed him for disclosure. No ordinary investor had the resources to see through this fraud. But managers of funds of funds did have the knowledge and time to uncover what Markopolos and others suspected — and whether from laziness or corrupt reasons they failed their clients.
Well, some fund managers did see a problem with the pitch and passed, at least one I heard of on the radio.
I’m wonder what the prospects are of calling in the paid out funds, which can be called back in since they resulted from fraud, and paying investors back. This has been done before, according to another article on NPR. Not all funds were recovered, but a significant amount.
With regard to three-card Monte, there are actually several moves involved. The one you describe is just part of the shuffle. If you manage to guess correctly once the cards have stopped, another sleight of hand can be used to make it look like your choice was revealed even though it was not. Basically, you flip one card over with another and in so doing really flip over a losing card.
Also, along with shills you will usually have muscle, and of course your muscle or another shill can just call out, “Run, the cops!” Game over.
Really though, this isn’t much of an example. Even if the game is fair, your odds are worse than the house. Even without any other facts, those you can see are pretty clear.
If it seems too good to be true, it is.
Even though it’s written snarkily,
http://longorshortcapital.com/doing-diligence.htm
shows exactly what investors should have been skeptical of.
Don’t trust a guy whose name is pronounced made-off. Ok, that’s unfair to the innocent Madoffs, sorry.
It’s kind of hard to avoid a Ponzi scheme when much of the financial system is based on it.
http://www.cfo.com/article.cfm/8878477/c_8877012?f=home_todayinfinance
Mitchell, some of Madoff’s victims were charities that had to lay off their staff and shut down.
Here’s a good article on how to spot this kind of Wall St crook:
http://www.ritholtz.com/blog/2008/12/be-wary-of-serial-correlation/
Of course it won’t help you catch other kinds of crooks.
In Madoff’s case there were several warning signs: co-mingled funds, internal auditing, no electronic access to funds or reports (extremely odd for a fund this size), no trade reports. Ironically many people who invested with Madoff spotted these problems and thought that he was running a scam like front-running orders which made them more keen to invest. It sounds like many other people were going off reputation alone and hadn’t really looked into the question which is a shame.
Re “diversify” – this sounds too glib and vague to be of use. What do you mean and how are we supposed to follow it? Diversify across investment classes and sectors makes sense but Madoff was running a fund which supposedly did this so putting all your money in the fund already was diversified. Now we start having meta-diversification where we diversify across several diversified funds but this is a major headache to juggle and balance so people who made their money doing something other than trading hire an advisor or invest in “funds of funds”. But this still exposes us to the risk of a bad advisor or bad funds of funds so we must diversify across many diversified diversifications, using dozens of funds of funds and dozens of advisors and presumably dozens of different banks or trading firms.
Who outside of professional traders can do this and to what end? These people will end up spending hours per week and millions each year in extra commissions and management fees to achieve some impossible level of “diversification” only to find that they’ve created a very expensive mirror of the S&P or a balanced hedge fund and for what?
How do we diversify the federal Ponzi scheme known as Social Security?
How to avoid scams:
Invest directly (or as directly as possible) in people who are doing productive work. Like digging up raw materials, or turning raw materials into useful stuff, or providing useful services to people or companies. Most companies in any of the big stock indexes fall into this category, which is why investing in index funds generally works.
Don’t invest in any company or person who makes money by shuffling money around, unless you’re a financial expert and really, truly, deeply understand what’s going on. And realize that NOBODY really, truly, deeply understands our financial system…
First, understand that most of the Madoff investors were put into his funds through financial advisors rather than directly. Financial advisors need to certify to their clients that they do due diligence with respect to recommended investments. Due diligence requires that advisors insist on verifying the assets a hedge fund claims to own. Verification of those assets would include independently verifying those holdings, by having them certified by the asset company. E.g., if the hedge fund claims to hold x shares of y company, then due diligence requires that the financial advisor verify, from y company, that the shares are indeed held by the hedge fund. Likewise, if the fund is holding options, the financial advisor needs to verify, independently, that these contracts are valid.
Investors need to assure themselves that a financial advisor is performing due diligence with regard to his recommended investments. Inability on the part of the advisor to establish that he is indeed performing that basic due diligence is a flashing red light and screaming siren, signaling to potential investors that there’s something wrong.
By the way, calling Social Security “a Ponzi scheme” is just a con by folks who want to privatize it. I sure wish my Social Security account had been on Wall Street this year!
Social Security is an income transfer program. It is solvent as long as the annual revenues and expenditures are kept in balance. They are now, and could be made so for many decades into the future by the simple adjustment of removing the cap on FICA wages. Why hedge fund managers making billions of dollars for their work should pay the same maximum FICA tax ($6045 on 2007 wages) as guys who make $100K is something only the wealthiest among us can answer.
Gavin: which is why investing in index funds generally works
I guess you haven’t looked at any of the index fund returns in the last few years, have you?
This is a problem with the way mutual funds work in general, they must be fully invested and they are long-only. That’s why as of a month ago only one mutual fund was even net positive for 2008. People who went to cash or better yet started shorting have done well but this is only possible if you manage your own money or use a hedge fund, saying “index funds” is only appropriate for people who don’t mind having 50% drawdowns. Maybe that’s fine when you’re 20 but when you’re 50 or 60 and you’ve been saving for 30 years and a 50% drawdown could mean decades of savings lost and dramatic lifestyle changes it’s another matter entirely.
As the Wall Street saying goes, during bull markets returns are relative, during bear markets returns are absolute. What does it matter if I have beaten the S&P by 10% if I’m still down $400,000 in one year?
Not sure the three-card-monte analogy holds up very well for me. Even for the average Joe, a grimy piece of cardboard,three cards and an obviously fly by night operator crouched on a street corner are a far cry from millionaire players who can afford to buy the whole street, play Monopoly with real buildings and hire the knowledge needed to recognize and avoid such shady dealings. Greed is greed is greed.
You are wrong about cold fusion.
Cold fusion was replicated by thousands of professional scientists at Los Alamos, BARC and over 200 other world-class laboratories, and these replications were published in mainstream, peer-reviewed journals such as J. Electroanal. Chem. and Jap. J. Applied Physics. You will find a bibliography of over 3,000 papers and the full text from over 500 papers here:
http://lenr-canr.org
Before you discuss this — or any other research — I strongly recommend you first read the peer-reviewed literature on the subject.
– Jed Rothwell
Librarian, LENR-CANR.org
Deregulation is clearly the answer!
Oh what this site could have been…
Watson: Social Security is in no way shape or form a Ponzi Scheme, and it isn’t rational to make such a nonsense claim.
Let’s pretend we had done what you want, and had “diversified” social security when Bush and the free-market acolytes had wanted to. It would be completely wiped out right now. SSI was put in place to protect the public from greedy free-market capitalists that nearly destroyed this country in the 30s. The very same people that now have us in this mess today. The same people that would have loved to have gotten their hands on the nations SSI funds, and would have squandered it.
For the supposed value placed on rational thinking, and skepticism, on this site, I just astounds me that this pervasive belief in the invisible hand is irrationally embraced by so many here…
An unregulated market, and no public safety net, is what got us the Great Depression.
SS is a Ponzi scheme that does work because each succeeding generation is compelled to participate. As far as free market ideology, I understand the frustration. I quit Skeptical Inquirer because of the constant leftist bias. But here it’s just a different bias. People become very unskeptical when their belief systems are challenged.
Opinionated Old Fart says “SS is a Ponzi scheme that does work because each succeeding generation is compelled to participate.” That defines the entire public sector. If I weren’t so compelled, do you think I’d contribute tens of thousands of dollars every year to the Pentagon? Or to ethanol subsidies? Or hundreds of other federal, state and local activities that don’t happen to be on my personal preference list?
He may be an OOF, but he’s not a very helpful commentator on the current scene.
Ponzi schemes work until a large number of people decide to withdraw. Like, say, retiring baby boomers.
Again, you’re flat out wrong, Max. The retiring boomers aren’t going to suddenly collapse the federal government, unless you think the government itself is some elaborate ponzi scheme.
“Ponzi schemes work until a large number of people decide to withdraw. Like, say, retiring baby boomers.” WtF does that mean?
Millions of people retire and begin drawing SS every year. Ponzi schemes fail when the amount being withdrawn overwhelms the amount being paid in–and there are no reserves. SS has billions of reserves in the form of U.S. Treasury bonds. When those fail, the whole country fails. If you think that’s imminent, you’d better move…but where?
I’m not too sure about this blog. I’d like Michael to diss religion and pseudo-science, but he seems intent on cramming The Free Market down our throats. It’s great that every time he does that people call him on it, but what happened to Skeptic=Non-belief in god(s)? If ya’ll think that’s gotten old, I work at a public school and had to listen to Xmas music every morning over the loudspeaker.
http://www.sfgate.com/cgi-bin/article.cgi?file=/c/a/2005/06/05/ING9QD1E5Q1.DTL&type=printable
Milton Friedman calls Social Security, created by President Franklin Roosevelt in 1935, a Ponzi game.
That Social Security operates on a similar basis is not really in dispute. Paul Samuelson, who won his Nobel Prize in economics six years before Friedman and shared a Newsweek column with him in the 1960s, called Social Security “a Ponzi scheme that works.”
“The beauty about social insurance is that it is actuarially unsound,” Samuelson wrote in an oft-quoted 1967 column. “Everyone who reaches retirement age is given benefit privileges that far exceed anything he has paid in … A growing nation is the greatest Ponzi game ever contrived.”
Today, 38 years after Samuelson wrote this, the number of people collecting benefits is about to rise steeply as Baby Boomers retire, reversing the flow of the system’s finances…
Asked why, if Social Security is so terrible, it is the most popular government program in American history, Friedman replied, “Well, because why does a Ponzi game work? It’s easy to understand why it’s popular. So far, on the average, retirees have gotten more out of the system than they put into it.”
devora,
atheist = non-belief in gods
And the fact that it was labeled a Ponzi scheme by non other than Milton Friedman should set up every skeptic’s red lights.
Apply some skepticism to Friedman’s ideas on the free market, and you’ll be a lot better off, because those ideas aren’t based on any type of scientific thinking, but are based on pure ideology.
The belief in the free market isn’t scientific, and it isn’t skeptical.
As a Certified Financial Planner, I can state somewhat authoritatively that there was no way any regular investor could have known with certainty that Madoff’s fund was a scam. Michael is right. There was enough information to have been skeptical of the fund’s claims, but that does not necessarily allow one to conclude that the whole thing is fraudulent.
We have regulatory agencies to keep firms like these honest. Far more than gullible individual investors it was inept regulators and greedy middlemen–who possibly profited more than Madoff himself, convincing themselves along the way that all was kosher–who enabled and facilitated the scam.
Well, the reading I’ve done, which includes statements from the general accounting office, seems to indicate that social security is not a Ponzi scheme. I believe the people who want to think so are letting a healthy skepticism about how well our government represents our interests run a little wild. No worries, they’ll have us back on the gold standard, or better yet back to bartering goats in the street, in no time.
Granted, at the beginning in 1935 it sounded a lot more like a government backed Ponzi scheme than it does today. Still, what other Ponzi scheme can claim the full backing of the US government?
Actually, with all this reading, I’ve kinda lost my taste for these “control your own money, invest it yourself” schemes. You can’t vote yourself bread and circuses through Wall Street ;-)
Jed Rothwell wrote:
“You are wrong about cold fusion.”
Being the curious kind and not wanting to trust such an important possibility to anyone, I went to http://lenr-canr.org and read some of the latest papers. Holy sh*t, there really are thousands of papers on this topic! The evidence actually is overwhelming that something very new is going on, although many are not so quick to call it fusion anymore. But the process, whatever it is, is definitely nuclear in origin because the energy out is orders of magnitude beyond what chemical processes can generate; and they have clear, repeatable evidence of Helium-4 and energetic particles… and these things do not show up in control experiments, so it seems the scientists have taken to heart the original criticisms and accounted for all other explanations… IF what I’ve read so far is indeed happening, then this technology deserves serious funding since it gives us access to the tremendous energy in nuclear processes WITHOUT the ‘crap’ (radioactive waste); the products are heat and helium! Both of commercial value…
Shame on you Michael Shermer; makes me wonder just how uninformed you are about other topics you report on. What’s more important, to be accurate, or just to criticize???
– Mark
A few days after the Madoff scheme became public, I saw for the first time, an Amway commercial.
I think I was watching football on Sunday. It was an expensive commercial. Did anyone else see it?
Why isn’t Amway investigated, besides they pay off politicians?
Beelzebud,
What specific ideas of Friedman’s aren’t skeptical enough for you? Could you provide examples?
tudza,
You write: “Granted, at the beginning in 1935 it sounded a lot more like a government backed Ponzi scheme than it does today. Still, what other Ponzi scheme can claim the full backing of the US government?”
Let’s think about this. What you’re saying is that this is not necessarily a Ponzi scheme because it has the backing of the government. But where does the government get the money? The very same taxpayers who are paying into and taking out of the Social Security system. If the government cannot pay, it can tax the very people it needs to pay to pay them. It may be more financially sound that most Ponzi schemes, but let’s be honest: it was built to pay older taxpayers with money from newer taxpayers.
mikeb,
You are right that if the bonds don’t pay out, the country fails (and spectacularly). But why won’t the bonds pay out? The government wouldn’t have funds. Why is that? Because tax revenues are insufficient. So, let’s summarize: Social Security won’t be able to pay out if there isn’t enough revenue coming in from future taxpayers to pay current taxpayers. Now, replace “Social Security” with “Madoff” and “taxpayers” with “investors.” You are right that if bonds fail, there are bigger problems. Nevertheless, that doesn’t mean Social Security isn’t designed like a Ponzi scheme. It’s just a rather well-funded one.
I dispute that the media *in general* has been portraying Madoff’s victims as “suckers”. Google News returned 7958 hits on “Madoff victims” and only 78 on “Madoff suckers.” This corresponds to my personal experience which is that the media has been mostly sympathetic with the victims.
Dr. Shermer: Seems to me that he only safe way is to restrict your investments to choices where the principle is guaranteed. Instead of being greedy, people should be satisfied with 5% return, or enough to offset inflation. The emotions of fear (includes the fact that loss hurts twice as much as gain feels good) and greed explain much human behavior, as I’m sure you know, but I’m just reminding other skeptics. Many smart people fail to heed the warning that past performance is no guarantee of future success–even applicable to the entire stock market; i.e., there’s no guarantee that the Dow will come back to previous highest point–ever.
Your kidding aren’t you. Worrying over some guys named Ponzi and Madoff. We got 12 Trillion in national debt. How’s that working for ya? The stock market and the private sector are all about the “Ponz” Getting something for nothing. You buy a house it appreciates, great. It loses value you look for someone to blame. Some guy says invest with me and his investment flops and he gets carted off to the pokey. Name a company in the last 50 years that went under just because it wasn’t competitive or even a good idea. Should they go to jail? No they are just bad business men. If Madoff lied then he should get the “go to jail” treatment BUT come on guys, if there weren’t foolish people in the world there wouldn’t be an economy. So riddle me this. “Why should I care its just good business”. See ya in church….
What’s an investor to do? Diversify is your advice. If anyone should know that there is no surefire way to avoide being conned, it would be Michael Shermer.
Maybe we should first ask, should you be an investor? If the answer is yes and you diversify with one broker you can’t avoid feeling like a sucker if (a) he runs off with your money; (b) you trust him so much you don’t even look at your portfolio to see that he’s probably running a Ponzi scheme with your money (all you care about is that he sends you a check in the amount you want every month); or (c) his firm goes under and (d) you live in a place where your government isn’t backing every loser in business as long as he loses big enough or is so interconnected with other losers that when one goes, they all go.
If the answer is yes and you put your money in several different institutions and diversify, you might avoid the risk of one fellow running off with all your money but now you have to investigate several people and the institutions they represent with who knows what new risks. In any case, diversifying won’t help if you don’t do the legwork and investigate anyone you are about to hand over a large sum of money to.
Most of us are too lazy and trusting to investigate anyone or any thing. Or, in the case of investigative skeptics, we turn over every page in quest of a psychic scam by a total stranger who we’d never give a dime to, while handing over our life savings to a guy in a dark suit with a reputable firm printed on a little card he carries in his wallet.
Whenever I hear someone say, the market will bounce back….it always does…I’m reminded of the chicken in Bertrand Russell’s example of the problem of induction.
Investing is putting money into something you know and understand.
Giving money to a high profile manager is a game. In games sometimes you win, sometimes you lose.
You can be wrong about an investment- who would know that we would still be using oil when we could be using solar? (eg)
Social security is a ponzi scheme by definition. If you don’t know that, then you should just look at the definitions- there is no argument- it is a fact.
sonic writes: “Social security is a ponzi scheme by definition. If you don’t know that, then you should just look at the definitions- there is no argument- it is a fact.”
A “Ponzi scheme” is a method of scamming people by telling them that they are “investing” and receiving “dividends” when in fact they are providing and then receiving transfer payments to and from other scamees. When the number of new scamees falls of, or the ones already on board begin wanting their “investments” back, the scheme inevitably comes crashing down.
Social ‘Security is an explicit income transfer strategy for subsidizing people who have reduced income-earning potential by taxing the income of earners. Is it totally equitable? Of course not: it overtaxes lower-income earners and it provides subsidies to classes of people (elderly, disabled) without regard to their actual need.
Does it have the potential for failing? Certainly. But, is the existing Social Security system in jeopardy of failing in the foreseeable future? Of course not. It will continue to accumulate more assets than it distributes for another ten years or so. And it will have accumulated enough assets–government bonds–to pay benefits for another three decades or so after that…even if there is no further adjustment in the revenue or benefit parameters. Small adjustments in both–such as removing the present-day $98,000 cap on FICA-taxable earnings and/or modifying the formula by which COLA is calculated for benefits–would extend the viability of the system for many decades beyond that.
Most people who call Social Security a Ponzi scheme, thereby implying that it is in jeopardy, have as their agenda either shutting the system down completely or “privatizing” it. Like to consider where we’d be today if the system had been privatized back in 2001 as the president and many of his supporters were advising?
Why did a lot of smart people trust Bernard Madoff, even though his fund delivered results that were “too good to be true”? Probably a lot of Madoff investors thought (or suspected) that he was engaged in insider trading. Of course it’s illegal, but there’s a lot of insider trading on Wall Street. So the investors were getting in on a good thing. Madoff had been in business for 48 years, was a former chairman of the NASDAQ. He was a shrewd salesman: after getting a buzz about what great returns his investments were getting, he would turn down would-be investors. This naturally made the investors desperate to get in on a great opportunity!
The SS system is labeled a Ponzi scheme based on current conditions. I could be wrong, as I often am, but in part it has been turned into a Ponzi-like scheme by politicians having free access to the funds. Those maligned baby boomers paid a lot of money into it, and the system would be solvent had not a lot of it been used for other purposes. SS contributions are still in the general fund, available to politicians who prefer advancing short term goals to long term planning.
I agree that diversification is the lesson, but that it’s of a different sort than people normally think. The Madoff scandal was made possible by leveraging trust. Because he was trusted by so many trustworthy people, he was able to convert his highly leveraged trust into dollars and more trust.
It’s impossible to avoid trust when making investment decisions at some point. Therefore to guard against being collateral damage, you have to spread your bets in terms of money managers and institutions.
Does anyone seriously think a this point that T-bills are 100% safe?
What most people of the “SS is a ponzi scheme” fail to take into account is that if SS will be insufficient to take care of future retirees, then nothing else will be, either. SS is a mechanism for transferring real resources (goods and services) from the current working population that produces them to the non-working population that consumes but does not produce. It depends on a sufficient surplus of production to support the fraction of non-workers (children, retirees, idle rich, etc.). Even if there is a growing ratio of non-workers to workers, the system can still work fine if productivity increases at a rate sufficient to allow more production per worker (i.e., a farmer with a GPS-guided tractor can feed a lot more people than a farmer with a hoe).
All clear? Then think on this: this dynamic of transfer from workers to non-workers holds, regardless of the financial particulars of the transfer. In other words, private investment instruments such as stocks and bonds are simply an alternative (and particularly inefficient) way of doing the same thing SS does with a direct tax-these-guys-and-pay-these-guys model. Pushers of SS privatization would dearly like you to not understand this, and think that changing a few numbers on a spreadsheet will somehow magically make real goods and services appear in the future…
madoff succeeded as long as he did because he not only
had all those feeders, but because it seemed to be
an “honor” to be taken on by him! and if no end of
people have been happily getting a good return for
many years, there is no particular reason to become
skeptical, unless you want to become skeptical
about the entire house of cards that is called
capitalism which is just another, but the biggest ponzi sc\
scheme of them all!
SS Ponzi Contributors, I quote our annual Social Security Statement verbatum:
“About Social Security’s future…
Social Security is a compact between generations. For decades, America has kept the promise of security for its workers and their families. Now, however, the Social Security system is facing serious financial problems, and action is needed soon to make sure the system will be sound when today’s younger workers are ready for retirement.
In 2017 we will begin paying more in benefits than we collect in taxes. Without changes, by 2041 the Social Security Trust Fund will be exhausted* and there will be enough money to pay only about 78 cents for each dollar of scheduled benefits. We need to resolve these issues soon to make sure Social Security continues to provide a foundation of protection for future generations.”
I love the usage of “compact”, but I digress.
I feel educated and enlightened by the comments above. Both sides. The conclusion I draw for SS is that changes are needed. Otherwise SS will fail.
It is sad, but the end will determine the “definition” of SS. If our legislature fails to act appropriately, SS will forever be labeled as a Ponzi scheme. If our legislature takes the necessary actions, this system will continue.
I congratulate those who introduced me to these gems:
http://longorshortcapital.com/doing-diligence.htm
http://www.ritholtz.com/blog/2008/12/be-wary-of-serial-correlation/
I’d love to see this blod improved to hide the garbage, and display more of these gems. heehee
I was interested in this issue because I’d read that some institutions had passed because Madoff was not monitored, I think. It is obvious to me that true due diligence should have enabled the astute individual to pass.
Sorry, but i think your answer, ‘diversify’ is insufficient,
Since that would have wasted whatever portion was invested in Ponzi.
Michael,
1. There is no one decision rule which would prevent you from investing in a Ponzi scheme. Diversify might practically fail when the diversification was into several asset classes which actually were feeders for the scheme. This appears to have happened in the Madoff fraud, a number of investors appear to be unaware that there money manager wasn’t diversified. (Of course, we could always define “diversify” to mean “pick a number of schemes in which there is a low probability that the investments returns are fake.” But that is purely theoretical.)
2. Madoff ran a scheme in which the true compensation rate for his sellers should have given investors concern. Your friendly hedge manager was doing 2/20 in Madoff’s scheme, but Madoff was only charging the hedge fund commissions. Hard to spot this, though.
3. The non volatility of the returns is probably the only red flag that we could expect more education to spot. There simply is no such thing as a no risk high relative to market return. Madoff’s returns if real would have allowed him to set himself up as the new Savings and Loan – borrow at rates from the Fed lower than his investment return. He would have never needed to use private capital. This economic attitude of seeing what it is in for the other guy might have been useful in the Madoff case.
4. The affinity fraud aspect of the Madoff fraud is not clearly understood at this point. Typically an affinity fraud works well by relying upon the halo effect: X is a well known authority in field Y, so if X recommends financial investment Z, the investment is recommended by an authority. Usually, with the form of unconventional bribes a con man can secure the blessing of two or three influencers who hold great sway. At this point, this network in the Madoff case is not clearly known.
5. The trick of scarcity and regret were also neatly played by Madoff. Combined with social proof, look everyone is making money in this -are you in?, a general investment euphoria, the illusion of being invited to a special party takes on great force. Getting into the Madoff funds was apparently portrayed as a very big deal.
6. The SEC, like all regulators, is a complaint driven organization. With none of the investors complaining, as they were getting paid, and the feeders not complaining because of their fees, it is understandable why the SEC didn’t take any action. This is one of the first schemes I have seen in which the principal essentially turned himself in, without there being an ongoing investigation.
Finally, the overall resolution to this type of problem is unlikely to simply be increased education or increased regulatory powers. (Personally, I like Joel Greenblatt’s take on personal investing: most of us have no business expecting anything more than a market return, for better or worse. But his actual advice works because most people are unable to follow it consistently!)
See Shermer, you and others of your ilk have an Establishment Bias, you are all trivially easy to fool because you love respectability. You probably even swallowed the dumbass USA milgov’s Official Boxcutter Fairytale of 9-11.
I know its useless to post this here, and I’ll be dismissed like the 9/11 truthers above, but really, all of this applies to Global Warming Hysteria. The acceptance of GWH by scientific skeptic societies is truly disappointing.
Mr. Shermer,
You ask: “What signs and signals were there for the average investor to see?”
I would direct your attention to the fact that Madoff’s accountant was a TWO PERSON FIRM NO ALMOST ONE HAD HEARD OF. In light of the Enron scandal and seeing how it took down Arthur Anderson (one of the largest audit firms in the world at that time), would you not see a giant red flag when a huge operation such as Madoff’s did not use a premier firm? The big firms are extremely careful these days in signing off in light of Enron. Would you not wonder what was wrong with this operation that they did not have the backing of the likes of Deloitte & Touche or Ernst & Young?
If I had millions of dollars to invest, you can bet your life that when I found Madoff was using Joe the Accountant to do his books because he could not get a major firm, I would run like h*ll the other way.
Is that a big enough sign for you? Even the brightest get duped, but it was easily detected none the less.
my eponymous law! :). (Benford’s Law);
also serial correlation as alluded to the the post by Riholtz and in the book Hedge Funds by Andrew Lo.
Great. First we’re told that being a shill for Friedman’s free market is skeptical thinking, now the global warming deniers and 9/11 truthers are coming out of the woodwork.
Oh what could have been. It was a good idea, but if you really want to start a TV show based on skepticism, maybe you should take a look at the types of ideas Mr Shermer seems to think are “proven science”.
I work in Quality Assurance, and one thing that I’ve learned is to watch out for consistency. If things are too consistant, that usually means there’s a problem.
Unfortunately, those are things you live and learn.
The people who think SS isn’t a ponzi scheme are just plain daft. Yes, currently SS generates more revenue than it pays out, but that doesn’t mean there are reserves to draw from or that it’s well funded. Sorry to break the bad news to you but there is no SS lock box. All revenue from SS goes into the general fund… and is already spent ~ looked at our annual deficits lately? Treasury Bonds are not an asset of the Gov’t, they are a liability. They are monies owed with interest to various parties. Treasury Bonds are a very large part of our Governments Ponzi scheme, without which our government would have to be financially responsible.
As it is, our Government is the largest Ponzi scheme running. The reason they get away with it is they have used the money coming in to build up the worlds premier ARMY, NAVY, AIRFORCE and a network of fairly efficient and ruthless Federal, State and Local police forces to quell disturbances (encouraging excessive force in every situation as a deterrent to others) before effective resistance can be organized. The only reason our Government continues to operate isn’t from the good will of the people, or other nations, it is the threat they pose if we don’t comply. Our Government is really just a mob running a protection racket, with a gun to our collective heads… you will finance our Ponzi scheme or else.
Cheers.
Yeah that’s called being a citizen! If you don’t like this country, you really should leave!
So much for skeptic thought. Being skeptical is fine, but stating that the US government is just an elaborate ponzi scheme, is just stupid.
If you hate the way our modern society works, then perhaps you should move to a 3rd world country and see how the “free market” treats you there.
What is disturbing about Madhoff’s ponzi scheme isn’t that any one individual
fell for such a thing – history tells us poignantly anyone can – but rather that the
institutional systems put in place couldn’t detect it. Many who were duped
were institutional investors who are suppose to have proper protocols, procedures and systems in place to guard against human gullibility. On top of that, the SEC is suppose
to be another safeguard. None of these safeguards worked. The system completely
failed. I do believe the system should have caught it. That’s the real story.
But to your question, I agree that it is perfectly reasonable that an individual would
be taken in by this. After all, Warren Buffet has been chalking up more impressive
returns for a longer period of time than Madhoff, so there is evidence it can be done.
I have a harsher opinion of those who over allocated to his fund, however. The
person who put all or nearly all, or even 30%, of his cash with Madhoff is guilty of
the greatest level of gullibility – believing that he knows what he doesn’t know.
As you point out, diversification is the answer. But speaking more deeply, it’s about one guarding against his own inability to know by taking precautionary steps such as diversification, even if it means giving up attractive performance. Incidentally, this is where I disagree with Greenspan’s analysis. He says that he doesn’t believe he was being greedy because he wasn’t looking for “get rich” returns, but in the context that I speak, he was greedy because he invested too much money on the “best hoarse.”
why is it that economics gets twice as much commentary as anything else on this site?
As one comment above suggests, SS is a “latent” Ponzi scheme, in that the management of the program by current and future governments determines whether the inter-generational transfers continue or collapse due to program mis-management. The “privatization” approach depends on trusting a multitude of individually selected “financial shepherds” to manage the funds, versus trusting the a single centralized state “financial shepherd” to keep the transfer scheme working.
If neither choice can be trusted, you’re on your own. Recent events have certainly impaired both groups, I think.
I would like to summarize the comments so far. ” I’m so smart, you are stupid and lazy and ignorant. I would have recognized this scam instantly because of my incredible intellect and financial accumen. I don’t feel bad for anyone who was swindled because stupid people deserve it. SS seems to work like a ponzi scheme. You are a dumbass buffoon, it is not like a ponzi scheme. Yes it is, no it isn’t, yes it is, no it isn’t. Why should we be skeptical of anything except religon? Other subjects bore me. Mr. Shermer implied that something I believe is true, is really false. Damn you Shermer, you are a lousy human being, you better research things and make sure you agree with me before you ever print anything again. You have the audacity to criticize the government? Get out of the USA right now! You should not live here if you have ideas that are not the same as
mine.”
There’s nothing wrong with Social Security that can’t be solved by increasing emigration.
Social Security is the band aid government uses to compensate for the financial illiteracy of the population. Anyone with half a brain can get better returns on the funds that are put into social security. Schools should be required to teach financial literacy and spend less time on Shakespeare and gym, no offence to the teachers of those subjects.
How to protect oneself completely from victimization by the next Madoff?
My answer: not possible
Think about it.
Human intercourse is based on trust.
When we meet someone first time we give them benefit of the doubt for being who they say they are. We do not ask them to whip out their drivers license to show us a picture id confirming that the person who is in front of us is who they say they are. And even if we did that, we could still be fooled, if someone impersonated themselves by forging the picture on the drivers license.
This example is just to give an idea of the scope of the problem if trying to completely prevent future deceptions by the Madoffs of the world.
Our entire society is based on an assumption that the person, or institutions we are dealing with are, in fact, who they represent themselves to be.
Absent operating on such assumptions, nothing could happen in a society as we would be spending all our time confirming what someone said, or did; instead of moving on and acting on such representations.
Think about how many interactions you have daily which are based on assumptions that you don’t have to do a separate individual ‘reality check’ everytime you interact with someone.
Based on the way our world is organized, we – the 99.99999999% of us who abide by the rules and assumptions of our society – go about our business daily operating on the assumption that the other 99.999999% of the population is like us, also rule oberving.
The problem is that if a person like Madoff or an organization like Enron chooses to ‘game the system’ by not playing according to the rules we will miss it – if done carefully; as Madoff and Enron were able to get away with their illegal behavior for so long.
So, while President Reagan may have proceeded on the maxim: ‘Trust but verify’ – its easier to say than do, when dealing with everyday things.
If we didnt trust each other – ie take each other at ‘face value’ our commerce will slow to a crawl while we ‘prove’ every statement made by every person we encounter in our daily life.
If we do trust each other at ‘face value’, we open ourselves up to the inevitable possibility that someone we meet may not be the ‘genuine article’ – ie like Madoff.
Its a chance we have to take everyday. Its a cost of being alive.
Tom Williams
A victim of a Ponzi Meister 15 years ago, who stood in a long line of ‘financially sophisticated’ creditors in Bankruptcy Court.
I believe that if I am too dumb to understand how a given profit is being achieved, I should not be investing in it.
Terms like hedge fund, are nouns; static things. Profits are explained by verbs or actions along the lines of the MacCawber equation in David Copperfield by Charles Dickens; “make sure your expenses do not exceed your income.”
Many schemes make absolutely no attempt to explain the actual source of the proposed profit, apart from the concept of a spontaneous increase in the price of the so-called asset. The concept of capital gain can apply to a betting ticket should your horse win. All other capital gain schemes are actually a variation on this model. In the casino, some patrons win and some lose.
As Galbraith noted, in a good boom, the concept of recurrent yield is completely forgotten; let alone any evaluation of the future reliability of that yield.
Another clue arises from understanding how the proposed process is adding value. In a boom, apparent past performance tends to create Gurus whose opinions displace arithmetic value-adding as the basis for judging an investment. Past profit does not prove an added value; it can indicate fraud or patronage from a powerful elite who are running the scheme. Without Mr Ponzi’s fraudulent manipulation there would be no hint of a profit, because no real value-added profit is being achieved.
Currently in Australia, real estate netting less than 5% (without capital gain) and equally overpriced shares fit the above definition of unwise investments rather well. The Bear Market still has a way to go yet, except for the foolhardy who are seeing bargains by comparing today’s prices with yesterday’s. Those who are using tomorrow’s yields as the yardstick are likely to stay on the sidelines for a little longer. If you can’t put your shares in a drawer and live off the dividends, be very careful.
Admittedly, mine is a rather boring,conservative strategy, which often means I have little to contribute to dinner party conversations about exciting opportunities to make money without working. The latest scheme seems to involve watching the price of your shares move up and down on a computer screen and jumping ship when the trend line turns. Good luck, when George Soros decides to have a bit of fun with his billions of liquid capital.
The entire financial system inluding Madoff are operating a
21st Century Reverse Pyramid Market Scam. Your articles are old and smelly at least 300 years old.
Divisification and due diligence. I heard about a few STOCK BROKERS that invested and subsequently lost everything with Madoff. STOCK BROKERS!!! These people should’ve been able to at least figure out how he was supposedly making money, and if they couldn’t figure it out, they should’ve said no. But again, with affinity scams they even said their was an ‘allure of exclusivity’ or how some people had to wait years before being let into the scam. I really can’t believe it didn’t go bust back in 2001 when the tech bubble burst. It’s a saying as old as investing, Don’t put all your eggs in one basket. Limit each type of stock or business segment to no more than 10% of your overall portfolio
The company brokerages network will give you access to a large pool of people who’ve the details about companies for sale and buyers or investors searching for a organization venture. By producing great use from the information you have, you may be cutting a offer and make a handsome profit out from the transactions.