THE FINANCIAL LOBE: Madoff Exposed Investors' Weak Spots

By Michael S. Rosenwald
Sunday, January 4, 2009

One of the many mysteries of Bernie Madoff's alleged $50 billion Ponzi scheme is why so many people broke a cardinal rule of investing by over-allocating money in one position. Many investors -- charities, individual investors, even well-known fund managers -- have lost everything, right down to their last penny.

How could so many smart people do something that, in hindsight, seems so dim-witted? The answer is simple. No matter how accomplished, experienced or savvy, people succumb to age-old human behaviors -- and failings -- when making investment decisions.

"You cannot go get a glass of water if you have no feelings or emotions," said Denise Shull, a New York consultant who coaches investors and traders about how people make decisions.

"We walk around with the idea that we are logical when it comes to these decisions, but our brains are designed to use feelings and emotions as a short cut."

In over-allocating money to one position, investors are typically prone to several short cuts that get them in trouble. One primary mistake is uniquely intertwined with Madoff's alleged scheme -- the allure of consistent small gains. A chart of Madoff's purported returns shows a line going steadily up, month after month, 1 or 2 percent. Those kinds of gains are intoxicating. Richard Peterson, a psychiatrist who co-founded MarketPsych, a Los Angeles psychological and financial consulting group, said we actually fall in love with them.

"It's like a slot machine that pays you a little each time," he said. "Over time you kind of fall in love with that machine. You'll actually have the hormones and strong attachment and bonding. You trust it. You want more satisfaction from these gains."

Peterson pointed to a famous study in Taiwan showing that gamblers chose a strategy paying them repeated small amounts even if at some point they had to take a huge loss. In more than 200 trials, the gamblers were given different decks to select cards from. In one deck, on average four of the five cards produced small gains, while the fifth card wiped out the wins and led them down a money losing path. The other decks of cards produced, on average, four small losses and one big win, which netted out to overall gains. The researchers were stunned when, given a choice, gamblers continued to want to pull cards from the small-gain deck.

"We like these consistent gains," Peterson said. "You can't underestimate their power."

Timothy Maurer, a financial planner in Hunt Valley, Md., knows exactly what Peterson is talking about. He has a retired client with more than half her money tied up in a mutual fund that has consistently given her the exact amount of income she needs to live. "She has grown to rely on this thing," Maurer said. "It gives her comfort. But at some point, the exact opposite might be the case." By that, he means the investment could turn sour and really wreck his client's income -- and comfort.

The Madoff trap also exposed a persistent problem among all investors: the failure to do timely rebalancing of their portfolios. A remarkable AllianceBernstein survey of 1,000 investors showed that nearly 40 percent of investors without an adviser did not have an approach for allocating and rebalancing investments. Some 55 percent of those people reported that they never got around to doing it.

Most startling: 70 percent of investors, including those with an adviser, said they are prone to change their hairstyle more frequently than they rebalance their portfolio.

Investors -- especially those who got tricked by Madoff -- can become prey to their own trusting nature. Many investors were led to Madoff by similar connections in Jewish social and philanthropic circles. It's called affinity investing -- investors let their guard down and are liable to break investment rules when they are led to the water by someone they trust.

"If we trust somebody, not only do we trust them to take care of our kids or to go to dinner with them, but we trust our own decision-making to them," Peterson said. "If they decide to invest in something, we think they have done the due diligence. Or that they're smart, they know what they are doing."

Familiarity comforts and lulls us into thinking we are doing well. Studies show that individual investors and even mutual fund managers tend to invest more in companies located near them. What's really remarkable is that the comfort they derive from being near an investment -- perhaps thinking they will know more about the firm -- does not translate into bigger gains. In a paper called "The Local Bias of Individual Investors," Ning Zhu, a professor at the University of California at Davis, found that "investors tend to invest in companies with which they are familiar even though such familiarity is not particularly helpful to their equity investment."

But familiarity, especially when it comes to getting tips from friends, can breed a strange sort of competition. Shull, the New York investment coach, said that investors fear losing money and missing out on the investment that could be The One. "It's the fear of being inferior, fearing the other guy is going to do better," she said.

So, ignoring common investment wisdom, we commit more than we should to a "winner" like Madoff and sweep in our gains without doing our due diligence. And as our winner fattens our portfolio, we stick with him, falling in love rather than redistributing the gains for possibly better returns and our own protection.

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