Archive for December 13th, 2008
The In-Crowd and Investment Losses
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.
