We make money mistakes and financial fallacies because of the ways that our minds and our brains work. The Madoff tragedy illuminates some of the more prominent errors.
Exclusivity. The desire to be special, even “chosen” vaults someone beyond common sense to an emotional choice. Madoff appealed to his target’s desire for status by including them in an exclusive club, even turning down potential investors. One investor said, “You had to go to him—he didn’t come to you. The first two or three times he said, ‘Not yet.’ Until finally when he said ‘Yes’ you gave him every penny.”
Transference fallacy. Madoff was believable as an authority figure, especially confirmed by the fact that he was Chairman of the NASDAQ, a philanthropist, and had a huge following of admirers. We tend to idealize figures who portray confidence and manifest wealth in the hope of participating in some of their glory.
Social contagion. People are persuaded to join group momentum in order to participate, especially not to be left out. By reacting to trends, herd mentality creates trends.
Confirmation bias. Once you make a choice, the tendency to reinforce the belief that this is the best choice—to cherry pick data to confirm that you’ve made the right decision—obscures evidence to the contrary. People continued to invest, and invited their friends to invest with Madoff.
Proving your worth. Often the victims of a scam want to prove their worth. Madoff’s scam could have been his self-statement: insiders said he wished he had gone to Wharton or Stanford, but instead went to Hofstra University, so always felt he needed to prove something.
Specialness. Someone who offers an evocative promise that crystallizes vague, hazy dreams to make them seem vividly in reach can generate a cult-like following. The (scam) artist paints a picture to allow people to see what they want to see; then the victims project their own desires onto a promising story that crystallizes a fantasy of magical wealth. The scam artist is half of the co-created scam.
Greed. Emotion and immediacy will trump logic and thinking. The excitement of an opportunity places neurocircuitry in collaboration with a promise—a good story. When someone makes money, the region of the brain called the nucleus accumbens lights up. This is the same pleasure center that responds to other highs, even cocaine. The drive to obtain a reward can resemble the addictive response of cocaine: Both are processed by the pleasure center. When financial incentives present a strong allure, reason as well as motivation can be hijacked by the pleasure center.
What can we learn from the Madoff debacle?
Don’t make significant financial decisions when you’re vulnerable. Greater vulnerability occurs at times of crisis such as divorce, job loss, death in the family, or economic downturn.
Be wary of hearing what you want to hear. Once you make a decision, continue to objectively exam the decision and look for evidence that it is right, and that it is possibly the wrong decision. Notice when you cherry pick data to confirm your decision. If it seems too good to be true, it’s probably too good to be true.
No matter how chosen, special, or select a group you’re in, no matter how exclusive the club you belong to, continue to ask questions. His creation of exclusivity obviated questioning by the time a client was accepted. Jerry Oppenheimer in his book, Madoff With the Money (the best title for a book since adolescent psychologist Dr. Anthony Wolf’s Get Out of My Life, But First Could You Drop Me and Sheryl Off at the Mall) noted that Madoff surrounded himself by associates and staff who would not question him.
Be willing to sleep on it. There are few true emergencies in life, and investing is not one of them.
Following the lead of famous people into an investment is meaningless unless they became famous by investment success.
Three basic tenets of good writing apply to good investing: clarity, brevity, and simplicity. Madoff had a complex investing scheme that even other money managers admitted they didn’t understand.
You are the CEO of your own finances. It’s an ongoing job.
The logic of financial decisions resides at a different neural address than the pleasure center. Since our brains are wired for instant gratification, reason can be hijacked and held hostage—unless there’s a plan and you stick to it.
When a stock portfolio does well, someone may attribute this to talent and smartness. And it could be. Or not. My wife and I play heads-up poker, and she finally confessed that one of my “tells” is that when I happen to draw a really lucky hand, I have an smug look like I think I’m brilliant.