How Smart People Lose Their Shirt

According to the Wall Street Journal, the following people are among those who have been hit by the massive Madoff Ponzi scam-- using principle from current investors to pay high returns to earlier investors.

New York Mets owner Fred Wilpon, GMAC LLC Chairman J. Ezra Merkin and former Philadelphia Eagles owner Norman Braman were among the dozens of seemingly sophisticated investors who placed money on what could prove to be history's largest financial scam.

How could it be that the cream of the financial elite allowed themselves to be duped to as much as $50 billion? Part of the explanation lies in how Madoff found his marks.

Mr. Madoff tapped social networks in Dallas, Chicago, Boston and Minneapolis. In Minnesota, he attracted investors from Hillcrest Golf Club of St. Paul and Oak Ridge Country Club in Hopkins, investors say.

Madoff exploited tribal ties and his stature within those communities gave him deep wells of of capital. The industrial giants and socialites who came to him with him with fists full of money did so with the faith, hope, and love of sheep to the slaughter. Some of their motivation was avarice-- they had inside information that this money maven could give them two percent more on their money than anyone else. But who was that "anyone else"? Some of them where mainline banking and investing establishments that have since collapsed.

So what is the ground of our trust when it comes to making financial decisions? The economist John Maynard Keynes wrestled with that question. How, he asked, do rational people act under conditions of uncertainty and disquietude? His answer: people embrace "conventions"-- giving them the ilusioin that they are doing the right thing. "A sound banker," Keynes said, "when he is ruined, is ruined in a conventional and orthodox way." To understand the dynamic of this scam, it is to realize that investors were acting consistently with their ontological assumptions-- that past is prologue, that some people and institutions can be trusted, that some kinds of aberrant information can be disregarded, and so on. The effect is that investors turn into lemmings. Investing behavior is reinforced by the investing behavior of their uncles and aunts and their friends and family. In the crowd, there is safety and sanity, and thus the crowd must always be right.

But a contrarian strategy-- the crowd is never or seldom right-- is no winning strategy. Some stocks go to zero, after all. The economy generally and the stock market in particular is act of nature, more akin to the galloping of the wilderbeast over the savannah or the ebb and flow of tides. And trend following is often the correct approach as turns in trends can only be predicted by tea leaf readers. Thus, we should expect housing, stock, and oil prices to trend down and gold, tuition, and health costs to go up for as far as the eye can see. Furthermore, there is no sure way that we can determine a turning point in these trends.

For this reason, buy and hold strategies, as counter-intuitive as they may seem, do turn out to be a winning long-term strategy. But that is only based on the assumption that the future will be like the past. Also, concentration rather than diversification can be a long term winning strategy as well as an unmitigated catastrophe. It is within this realm of uncertainty the Madoff investors wrote their million dollar checks.

So what can we do to avoid the mistakes they made? First, we must realize that investment decisions arise not so much from rational thoughts as from subconscious desires-- for community, for affirmation, sometimes even the desire for self-punishment and so on. We must then try to shun those idols as alluring though they may be. And that can only be done through honest, critical thinking and accountability-based behavior. The questions we ask will give us the answers we need.