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?