Last week, I came across an interview with forensic accountant Harry Markopolos, who is best-known for being one of the earliest critics of Bernard Madoff’s Ponzi scheme in the early 2000s. While I think that the specifics of how Markopolos figured out the fraudulent nature of the scheme are interesting in and of themselves, what is equally interesting about this episode in financial history is why investors allowed themselves to be fooled in the first place.
After all, as Markopolos himself says, it didn’t take any particularly complex analysis on his part to figure out that something was off about Madoff. Why did so many (supposedly sophisticated) professional investors let themselves be misled? The answer to this question tells us a lot about investor psychology.
Manage your expectations
Contrary to popular belief, Madoff actually had most of his success outside of the United States. In particular, he became quite adept at luring in European investors via the large network of private banks that exist there. American banks, by comparison, seemed to have done a lot more due diligence, and a number of them even had Madoff on blacklists.
Markopolos thinks that European investors were lured into this scheme because of their preconceived notions as to what a "fair" return on invested capital should be:
“One of the things [that Madoff preyed up] was the fear of missing out. He was far bigger in Europe than he was in the United States...339 fund of funds and 59 management companies were invested with Madoff, in over 40 countries, of which 79 were in the US, and over 200 were in Europe. The Europeans thought that it was a God-given right to earn 15% to 20% returns in a year with very little volatility. And Bernie was offering 12%, with very little volatility - they were all into that, they thought that that existed.”
The key takeaway here is that people whose expectations are out of line with reality are more likely to be duped than those who know what can realistically happen in the financial universe. If you look at U.S. interest rates in the late 1990s and early 2000s, they only got above 6% once - in the latter half of 2000. Interest rates in the eurozone and Switzerland were even lower.
If the prevailing risk-free rate is only 3% to 4%, how can it be possible for someone to offer 12% with low volatility? The answer is that it’s not possible, but this was much less evident to Europeans than to Americans. Investors of all stripes should remember to always make sure that their economic assumptions are consistent with the facts.
Read more here:
- Is the Bull Market Running Out of Steam?
- Ray Dalio: 3 Big Levers Affecting the Economy
- Seth Klarman: The Uses and Misuses of Leverage
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