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Todd N Kenyon
Todd N Kenyon
Articles (5983)  | Author's Website |

Understanding the Madoff Fraud, Munger-style

December 17, 2008

I think the only thing more shocking than the Madoff fraud itself is that so many "accredited" or "sophisticated" investors were duped for so long. Everyone should try to learn a lesson from this, and be thankful if you're not one of the ones learning the hard way.

I have written previously about "Lollapalooza Effects"; a term coined by Warren Buffett's alter ego Charlie Munger to explain why smart people can be so darn stupid. Before we go further into Charlie-Land though, let's get a couple things straight:

It should now be painfully clear that having a certain net worth does not a "sophisticated" or "accredited" investor make. I hope the SEC is starting to understand this fact. Their last attempt to "protect" investors from the risks of hedge funds was to raise the net worth requirement to invest in one - as if someone worth $5M is better equipped to evaluate "alternative" investments than someone worth a mere $2M.

2nd, it should also be painfully clear that funds-of-funds as a general statement are no more than leaches in pin stripes, sucking the blood from lazy investors. The only possible justification for these guys' existence is that they do the due-diligence that individual investors can't or don't want to. Yet scores of them invested with Madoff and were paid handsomely to do so. Take the Tremont fund: 50% of it's assets ($3B) were invested with Madoff. For this great service they provided, for this "massive value" they created, they received $60 MILLION in management fees ANNUALLY.

Disgusting. This entire mess, including the credit crisis as a whole, takes a special kind of stupid. Someone recently coined it "Harvard stupid". But why pick on Harvard - let's just call it Ivy League stupid. Note that I am in no way condemning all or even most Ivy League grads - just those that wound up on Wall Street believing that they were smarter and more entitled than the rest of society, and that they should be paid ridiculous sums of money even though they created zero value.

I can't wait to see some of these guys wielding shovels as they help dig holes for some of Obama's infrastructure projects. I mean seriously, what can they do second best? Heck, what can they do first best? I am certain however that they can be trained to operate a shovel. At least then they will be creating value for mankind. Even the first shovel-full of dirt will create more value than their entire Wall Street careers.

We clearly cannot hold the investors blameless. But to get back to Munger and the Psychology of Human Misjudgement, it is easy to see how Madoff "made off" with so much money. He exploited several powerful human behavioral tendencies. These are behaviors hard-wired into each of us since our days roaming the plains of Africa. None of us can avoid these urges, and most of us fall victim to them. Our best defense, one championed by Munger, is to be aware of and understand them. And as powerful as these ancient "instincts" are, they excerpt exponentially more influence when several combine - Munger's "Lollapalooza Effect".

Madoff used country clubs and influential members therein to peddle his fund. Here we have a perfect environment for social proof and over-influence by authority. The influential, popular member was naturally assumed to "know more than us" - a common mental mistake. Second, we naturally love to do what others are doing, especially people we like (think about High School) and in a club setting you had several other members invested. Then you had the influence of "super deprival syndrome". The "big man on campus" would give the impression that the opportunity to invest in the fund was a "special privilege" not open to just anybody. This type of framing flipped the "I might miss out" switch. Humans hate to miss out on anything - in caveman days if you missed out on your share of mammoth meat it might be your last mistake. Anything that is perceived as scarce instantly becomes more attractive to us. So it was with Madoff's fund. And I'll even add a fourth driver: envy. As Munger says it's the worst of the Seven Deadly Sins because it's the only one that isn't any fun. You can imagine how those club members who were not yet in Madoff's fund were really "jonesing" to get in.

Each of those human biases are powerful - four of them together are a wrecking machine. As Jason Zweig said in a recent article, investors' fears were shifted from the risk of losing money to the risk of missing out on making money. This is one mistake that Buffett never makes when evaluating investments. I'll have a post soon on the real secret to Buffett's success, and his incredibly simple yet hard to execute analysis methodology.

Again - everyone should learn from this - these same biases effect each of us every day. Understanding their influence will give you an advantage in life. Exploiting their influence can also give you an advantge, at least until you wind up in jail or schlepping a shovel.

Todd Kenyon,

currently also an Investment Director for Investorwalk.com

About the author:

Rating: 3.7/5 (22 votes)


Traderashish - 9 years ago    Report SPAM
it is not that people with high net worth are more sophisticated, it is that they can afford to lose a large sum with out affecting the food on their table or education of children.

Also if they are rich because of their own efforts, then they are very smart as well. Being wealthy on your own requires certain kind of smarts not many people have.

Rich can gamble more and afford to lose more without going below the poverty line.
Dr. Paul Price
Dr. Paul Price - 9 years ago    Report SPAM
The biggest PONZI operator of all time is not Madoff but our own federal government- through the Social Security system.

They take our money month after month, give it all to the 'old' investors and then promise us we'll get paid later from AL Gore's famous, but non-existent (and empty), 'Lock Box'.

When the cash flow relationship of current year money coming in- versus money going out, gets very negative in the coming decades, our Social Security PONZI scheme will fall apart just as Madoff's did.

Commodity - 9 years ago    Report SPAM
Fraud will be around forever.

There is noway to protect against it.

Warren Buffett had no idea what Moody,s was

doing with the CDO rating.

Nobody ever has a clue that fraud is taking place.

Amit Chokshi
Amit Chokshi - 9 years ago    Report SPAM
Some of those same social forces might be at play when all of these supposed "contrarian" value investors (lemmings) all invest in the same stocks like SHLD, BGP, BKS, TGT, WINN, REXI because their heroes do.

Tkervin - 9 years ago    Report SPAM
What would happen if everyone in the US withdrew all of their money from the banking system at once?.........................ask Madoff......:-)
Itznuthin1 - 9 years ago    Report SPAM
To me, America is a giant ponzi scheme. A well operated one at that.

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