From Ponzi to Madoff: Why Do Investors Keep Falling for Fraud?
Whenever a Ponzi scheme makes headlines, it’s not uncommon for those unaffected by the scandal to wonder: How could the investors not have known? How could the broker have gotten away with such a massive fraud scheme for so long?
Bernie Madoff may have been the most famous financial fraudster since Ponzi himself, but there have been countless similar schemes over the last century. Clearly, those who deliberately defraud investors may not be so easy to catch. There are three primary reasons that Ponzi schemes continue to trick investors and the people around them: the charisma of the fraudsters themselves, our human propensity to hear only what we want to hear, and a whole lot of groupthink.
We inherently trust charisma
Most people’s image of a fraudster is someone who looks untrustworthy. We imagine someone who seems shifty, a career criminal with a predatory demeanor. This is not, generally speaking, who orchestrates Ponzi schemes.
Ponzi schemes are committed by people who have the capacity to inspire trust, and often by people who already have access to large swaths of investor money.
Charles Ponzi himself was not the first to perpetrate the scheme for which he was named, but he embodied the persona that came to be associated with this type of fraud. Ponzi was known to be extremely affable and charismatic, which is how he convinced thousands of people to “invest” in a fraudulent international postage stamp scheme. Had Ponzi been obviously suspicious, his investors probably wouldn’t have bothered to trust that particular investment plan.
With confidence and charisma, Ponzi perpetrators strive to convince investors that they know something about the market that the investors couldn’t possibly know. It’s important to remember in the age of digitally-accessible information that this is not the case. Even if you do not hold a degree in finance, there is no “secret” stock information that just one investment advisor has access to. Never accept an investment opportunity if you don’t understand how it works. It may take more time, but it certainly doesn’t hurt to seek an unbiased second opinion before you commit to a suspicious investment.
We hear what we want to hear
The reality of investments is that when you want a high return, you have to commit to a high risk. Ponzi schemers are effective because they make us feel that because our low-risk investments are not yielding astronomical returns, we are missing some fundamental yet hidden truth that could really turn things around for us financially. They prey on our adherence to the uniquely American fantasy that with the right information and plenty of hard work, it’s somehow possible for everyone to be a billionaire.
The truth is much less attractive: most people’s investments will yield low or modest returns. If you take a big risk with your investments, you can certainly win big–but you could just as easily (if not more easily) lose big. Any investment advisor who suggests that there is no way you can lose by making a risky investment is simply lying.
More often than not, we go with the crowd
Parents have long admonished their children for succumbing to social pressure, using the popular turn-of-phrase, “If your friends all jumped off a cliff, would you?” When it comes to Ponzi schemes, the answer to that question is quite often a resounding “yes.” It is incomprehensible to us that our friends, family or colleagues, who we admire and trust, who we believe to be smart–could possibly have been duped.
Especially in the early to middle stages of Ponzi schemes when early investors are yielding impressive (if misleading) returns, it’s even harder to believe that that success is somehow unwarranted.
This is largely how Bernie Madoff conned over $50 billion from investors. The more people signed up for his scheme, the less it looked like a scheme. Even though few could understand specifically how his clients were able to yield such favorable returns, investors went along for the ride because they thought were benefiting from it.
Even when a whistleblower, Harry Markopolos, attempted to warn the SEC and investors that Madoff was running an enormous scam, Madoff continued to receive the benefit of the doubt. The alarming reality is that Markopolos didn’t have secret, insider information–he used fully public information to ascertain that Madoff’s investment strategy was actually a Ponzi scheme. As we all later learned, Markopolos was right.
Learning to invest with caution
Investments are an undeniably essential part of the United States economy, and they give all citizens an opportunity to grow their wealth beyond what is possible solely in their careers. Investors who fall for fraud schemes are intelligent people–but like just about anyone, they trust the people whose job it is to help them make smart choices in specialized fields. The majority of brokers are absolutely trustworthy; sadly, enough of them aren’t that it’s important for all investors to approach each and every investment opportunity with extreme caution. Ultimately, you hire a broker to do most of the heavy lifting for you–but that doesn’t mean it’s safe to turn a blind eye, even and especially when your investments are working in your favor.