Oxymoron: Sophisticated Investor

WSJ: How Bernie Madoff Made Smart Folks Look Dumb:

What do George Carlin and Bernard Madoff have in common?

The late comedian immortalized oxymorons, those absurd word pairs like “jumbo shrimp” and “military intelligence.” Mr. Madoff just put the silliest of all financial oxymorons into the spotlight: “sophisticated investor.”

Seriously, this is an excellent case study in Behavioral Investing, a topic I hope to spend much more time discussing here soon. The WSJ story is worth reading.

Mr. Madoff emphasized secrecy, lending his investment accounts a mysterious allure and sense of exclusivity. The initial marketing often was in the hands of what one source described as “a macher” (the Yiddish term for a big shot). At the country club or another exclusive rendezvous, the macher would brag, “I’ve got my money invested with Madoff and he’s doing really well.” When his listener expressed interest, the macher would reply, “You can’t get in unless you’re invited…but I can probably get you in.”

Robert Cialdini, a psychology professor at Arizona State University and author of “Influence: Science and Practice,” calls this strategy “a triple-threat combination.” The “murkiness” of a hedge fund, he says, makes investors feel that it is “the inherent domain of people who know more than we do.” This uncertainty leads us to look for social proof: evidence that other people we trust have already decided to invest. And by playing up how exclusive his funds were, 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.” Once someone you respect went out of his way to grant you access, says Prof. Cialdini, it would seem almost an “insult” to do any further investigation. Mr. Madoff also was known to throw investors out of his funds for asking too many questions, so no one wanted to rock the boat.

Another perspective on how Madoff made-off with so much can be found in The Big Picture. Barry Ritholtz claims that part of the problem is that firms like mine simply don’t bother to do any due-diligence on hedge funds. He observes that there are now more hedge funds that there are stocks (!) and while we dedicate hundreds of analysts to covering stocks we assign only a small handful to covering hedge funds.

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