It bears worth repeating that the most interesting aspect of many of the recent Ponzi schemes that have surfaced, among them Bernie Madoff’s and Scott Rothstein’s, is not the motivation that propelled these individuals to commit these frauds, but the rationale of seemingly sophisticated investors and wealthy individuals to dispense with the due-diligence that would typically accompany investments in these funds.
This unexplored angle to these stories deserves significant scrutiny, not because it will prevent future fraudulent activity or greatly assist in the forensic examination of these crimes, but because it will shed light on the dynamics of human behavior and psychology, which are far more interesting and compelling. Most reporting of these stories attributes investor behavior to greed or the desire to earn outsize returns in a market largely devoid of enhanced earning vehicles.
This easy answer is convenient and may even be partially correct, but only strikes the surface of the dynamics and drivers that precipitated these frauds. Indeed, if greed was really the motivating factor for these investors, then it would be very easy in the future to trigger warning flags and alarms throughout the investment community once tell-tale characteristics or badges of fraud are detected, and prevent yet another scheme from hatching.
Unfortunately, human behavior is not nearly so linear, predictable or well-defined. Something much deeper, more profound, yet subtle was at play in at least these two frauds: our constant desire to receive attention from or align ourselves with elite membership in exclusive social organizations or clubs that are not otherwise available to “everyone else”. It’s really that simple.
While it’s a fact that Madoff mined his ethnic and religious ties within the Jewish community, and these ties greatly aided him in building false trust in that community, Madoff principally grew his scheme by cultivating the notion of exclusivity within his investors and feeder funds. This exclusivity propelled the Ponzi scheme to dizzying heights and constantly rewarded him with new investments.
Madoff understood that his “club” would not remain sufficiently enticing or compelling through simple appeals to his ethnic circle, or by repeatedly highlighting the steady and predictable returns generated by his fund. Madoff also understood that restricted membership in his investor club would be the carrot that would entice large numbers of wealthy individuals to his flock.
Potential investors were duped into assuming that if other, similarly spectacular and wealthy investors chose to participate in the Madoff fund, that alone would suffice as the acid test of Madoff’s credibilty. How others felt about Madoff would ultimately define these investors’ subjective feelings regarding their investments. The exclusivity of Madoff’s investor pool was the underlying driver that defined these feelings, and created the “Madoff Mystique”.
Similarly, Scott Rothstein’s Ponzi scheme appears to have blossomed once his association with “elite” financial and political groups within Florida became widely known and publicized. Although it does not appear that Rothstein sold investors on the notion of exclusive access to his investor pool directly, his high-level relationships and connections ultimately created the same emotional intoxication that surrounded Madoff.
Once established in investors’ minds, these notions became re-defined and confused as trust by these investors. Two pieces of excellent journalism, one about Madoff in Vanity Fair, here, and another about Rothstein in the Miami Herald, here, highlight the trust bestowed on these individuals by the wealthy and powerful. Investors granted Madoff and Rothstein their trust based not on any objective standard, but on subjective exhortations by other similarly misinformed investors.
These Ponzi schemes were created in much the same fashion as simple rumors, once they had established sufficient critical mass, they were nearly impossible to dispel and became firmly entrenched in the minds of most prospective fund investors. Madoff sold exclusivity and membership in an elite club, Rothstein sold his connectivity to Florida’s elite financial and political establishment. These intoxicants proved irresistible to thousands of very wealthy individuals, many of which deposited their life savings and earnings into the funds.
A core lesson here, though, is that investor behavior is increasingly driven by herd mentality tied to notions of exclusivity, uniqueness and intellectual superiority. These investors wanted to be different, to belong to exclusive groups that few others would have access to and achieve uncommon returns that would define them as intellectually superior. In the end, they too succumbed to herd behavior and the foolishness of crowds, although their herd was a club to which the rest of us are rarely granted access.
