Strategic Framing

The potential $50 billion loss is mindblowing.  Even if the losses from the Madoff Investment fraud comes in below this number it is still going to be a fraud of historic proportions.

To put it in perspective, the trading scandal that brought SocGen to its knees and rocked the markets in January 2008 was on the order of aproximately $7.1 billion.  If the sky was falling then, what’s falling now? (side note: If you are stressed and need to relax, close your eyes and try to answer that question.  What can be greater than the sky?  The question has a certain perverse zen like quality to it)

Now the conversation turns to the question: Why did so many people not see the warning signs?  We’ve learned that there were signs of something fishy at Madoff Investments.  The biggest one may be the low probability that any firm can continually generate such predictable returns  in variable markets.  Another warning sign was raised about the feasibility of Madoff’s reported investing strategy for a fund of such a size.

No doubt there are many answers to the question of missed warning signs.  Let me add the role of human psychology.  We depend upon social valuation to judge others in complex environments and we seek information that confirms our initial judgments.  Both these cognitive tendencies came into play in this case.

Madoff relied upon his reputation to bring in new investors.  His legitimacy as a financial professional came from his reputation.  His reputation was built up over such a long time that to spend time investigating Madoff’s expertise is easily dismissed as a waste of effort.   To use the political term in vogue these days,Madoff had been vetted and new investors could comfortably accept that.

Combine such strong reputational legitimacy with our natural bias towards confirming evidence and you have a receipe for fraud.  Our overweighting of data that supports our decisions and underweighting of data that disconfirms our decisions is well documented.  This is the same dynamic that causes politically conservative Americans to watch Fox News and politically liberal Americans to read Salon.com.  It is also the dynamic that prompts investors to discount negative analysis of companies in which they have invested.  Investors may claim the analyst is biased, missed a key point, or just doesn’t get it.  It is easy to rationalize why information is useless once you’ve decided the information is useless.  Madoff invested had $17 billion reasons to rationalize away warning signs.  They’d already made the decision to invest in Madoff.  That was the hard decision.  Seeing evidence to reinforce the correctness of that decision after the fact is easy…and natural.