Spero Consulting

Archive for December 13th, 2008

Three days ago in a post, Past Per­for­mance Is Not a Guar­an­tee…, we ref­er­enced the strug­gling invest­ment man­ager William H. Miller and wrote:

“We want to under­stand what causes or moti­vates peo­ple to lose their skepticism…and accept some­one as, say, a can’t-lose “genius” investor…rather than view him as a large risk (with, hope­fully, a cor­re­spond­ing large expected return). What hope or psy­cho­log­i­cal need per­mits such credulity?”

There are no alle­ga­tions of wrong-​doing on Mr. Miller’s part. It seems sim­ply that his luck ran out. The unfor­tu­nate aspect of his case as in many oth­ers was/​is the incor­rect attri­bu­tion of suc­cess to his abil­ity rather than his luck or a com­bi­na­tion of the two. (We all fall for that fal­lacy to var­i­ous degrees, espe­cially when it involves our own ability.)

It seems quite easy for folks – who lack the nec­es­sary degree of skep­ti­cal imag­i­na­tion – to err when mak­ing such infer­ences, espe­cially when gains are rel­a­tively steady and losses are rel­a­tively rare but large.

The arrest of Bernard Mad­off a day after that post and the sub­se­quent news reports as investors come for­ward admit­ting to extremely large losses makes us revisit the ques­tion. (Esti­mates of losses range near $50,000,000,000, and pros­e­cu­tors allege that Mr. Mad­off com­mit­ted fraud.)

His case is inter­est­ing because it seems that the reported returns in his invest­ment funds were incred­i­bly steady and sub­stan­tial and there were few, if any, losses until recently. That sequence is what made a few folks sus­pi­cious – some of those folks for quite some time – but, as it turns out, far too few.

Jason Zweig has a nice col­umn in the week­end edi­tion of The Wall Street Jour­nal, enti­tled How Bernie Mad­off Made Smart Folks Look Dumb, which to some degree addresses our ini­tial ques­tion per Mr. Miller.

Not being in their acquain­tance, we’re not sure of the intel­li­gence of the “Smart Folks” mentioned in the article’s title, but we are highly skep­ti­cal of their level of sophis­ti­ca­tion. In fact, when refer­ring to oth­ers, we usu­ally use that term pejo­ra­tively as it seems to related to either some notion of taste (for some­thing “exotic”) or some­thing overly-​complex and detailed (for no reason).

Besides their own greed, which is a nec­es­sary factor, it seems that cre­at­ing an aura (or mirage) of exclu­siv­ity is often a key fac­tor in trick­ing gullible investors.

In Mr. Zweig’s arti­cle, he para­phrases Robert Cial­dini by writ­ing “Mr. Mad­off shifted investors’ fears from the risk that they might lose money to the risk they might lose out on mak­ing money. If you did get invited in, then you were anointed a mem­ber of this par­tic­u­lar club of ‘sophis­ti­cated investors.’” So per­fectly sim­ple. That tech­nique preys on the investors envy and pride, but espe­cially the seem­ingly mas­sive need for accep­tance and affiliation.

It’s not just indi­vid­ual investors who fall for such tactics. As the many reports about Mr. Madoff’s arrest note, many insti­tu­tions invested heav­ily with Mr. Mad­off, too.

We lost count of the times in our career when we heard, “XYZ is doing it, so we should, too.” XYZ was usu­ally a big­ger, “more sophis­ti­cated” firm look­ing for oth­ers to bear its risk. Unfor­tu­nately, many of those XYZs have dis­ap­peared – usu­ally for self-​inflicted rea­sons often because they mis­cal­cu­lated the amount of risk that they had retained.

In the insti­tu­tional set­tings, some­times, the argu­ment was extended to: “if we don’t do this now, we won’t have the oppor­tu­nity to par­tic­i­pate in future deals.” (Many of those were equally as dubi­ous, too.) The jus­ti­fi­ca­tion was rarely eco­nomic but often relied on want­ing to be part of the in-​crowd.

When faced with those sit­u­a­tion, we thought shouldn’t the question(s) be: “Why the sud­den gen­eros­ity? Doesn’t the fact that they’re includ­ing us indi­cate some level of des­per­a­tion on their part?” Of course, we weren’t sophis­ti­cated enough to under­stand the attrac­tion – merely skep­ti­cal and cyn­i­cal. (By the way, this is the same mech­a­nism by which traders and invest­ment man­agers often co-​opt gullible (and needy) risk managers.

We often say – usu­ally to our­selves – never under­es­ti­mate the need for affiliation. 

Look no fur­ther than the stu­pid­ity of haz­ing rit­u­als or the preva­lence of school and team-​related para­pher­na­lia and apparel in our soci­ety. In that regard, one of the princesses likes to count the num­ber of Steeler jer­seys at Sun­day Mass. Our casual empiri­cism sug­gests that it is highly cor­re­lated with the team’s sea­sonal per­for­mance to date, which isn’t that dif­fer­ent than invest­ment per­for­mance; they’re both quite ephemeral.

A friend who has spent his career in cor­po­rate human resources has sug­gested that the need for affil­i­a­tion can over­whelm com­pen­sa­tion con­sid­er­a­tions for many aspir­ing indi­vid­u­als within firms. He wasn’t talk­ing about appren­tice­ships or junior employ­ees at, say, audit­ing firms who need work expe­ri­ence for licens­ing rea­sons. He was dis­cussing quite senior hires.

Our advice is sim­ple: in any situation, force your­self to put some weight – some prob­a­bil­ity – on the hypoth­e­sis that you’re being played, regard­less of your level of intel­li­gence and sophis­ti­ca­tion. Place some weight on the fact that oth­ers may have the audac­ity to try to cheat you.

Hey, every­body likes a win­ner and wants the approval of oth­ers, espe­cially their peers or bet­ters, right? We only give this advice so that you’ll like us. Right? Are you with us? Really? Seriously? Good, good. We feel much bet­ter now.

P.S. After hear­ing one woman on FoxNews this morn­ing we wouldn’t be sur­prised if many of Mr. Madoff’s for­mer investors argue that his anti-​social behav­ior did not begin until after they invested with him because, you know, they would have known if some­thing wasn’t quite right.