Bernie Madoff ran the largest ponzi scheme in the history of the world. The Ponzi was worth an estimated $65 billion in 2008! 

• Madoff took money from investors saying he would invest it in the market using his unique proprietary trading strategy that consistently yielded high returns with minimal risks. 
• But instead of actually investing the money, he just parked it in a bank. 
• He generated fake statements and transaction records to show impressive and steady returns. 
• And simply paid off old investors with money from new investors.

Till the ponzi grew and grew.

In 1999, Harry Markopolos complained to SEC that it is mathematically impossible to achieve the returns Madoff claims to deliver. After several hours of failed attempts to replicate Madoff’s numbers, Markopolos was sure that it was a fraud. But his complaints weren’t taken seriously.

Over the next decade, the SEC actually investigated Madoff 6 times after a few more complaints. But didn’t catch the Ponzi scheme. How did Madoff fool so many people, including many experts?

The Madoff presentation

Madoff had one thing going for him: his reputation. He was one of the pioneers of using computers to give automated market quotes all the way back in 1971. The technology that he helped develop became NASDAQ. 

He was also the pioneer of paying brokers for their order flow, so that they would allow him to execute their clients orders. For a short period of time, he was the biggest market maker for NASDAQ.

People believed that Madoff knew his stuff. His reputation preceded him. That helped immensely when he gave presentations to investors as well as investigators.

During his presentations, Madoff described a complex investment strategy involving split-strike conversions, which sounded sophisticated and plausible. He then showed them his historical records (all falsified), which showed steady growth.

Individually, each of Madoff’s claims were incredulous:

• Madoff had a unique and complex secret trading strategy
• Madoff consistently generated higher returns than others
• The investment was safe as Madoff had never had a negative year

Any single claim would probably raise your red flags. All the claims together would enter the realm of being highly improbable. But the opposite happened. 

Less likely claims – when stacked and combined together – made the whole thing more believable. How come?

The Linda problem

Amos Tversky and Daniel Kahneman ask a bunch of participants the following question:

Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.

Which is more probable?

1. Linda is a bank teller.
2. Linda is a bank teller and is active in the feminist movement.

More people opt for option 2 than option 1. 

If you think about it for more than a few minutes, you’ll realize that option 1 is a subset of option 2. Whenever option 2 is correct, option 1 has to be correct as well. So option 1 has a higher probability. But yet, more people opted for the reverse.

Why does excess detail and information befuddle us?

The conjunction fallacy

People incorrectly believe that two specific things happening together is more likely than just one of those things happening on its own. This psychological bias is known as the conjunction fallacy. The bias exists because:

1. We are terribly extremely bad at probabilistic reasoning.
2. We crave cognitive ease. We want our brains to process information smoothly.
3. We want to maintain the illusion of understanding. 

It’s because of this bias that Bernie Madoff could run his ponzi scheme and fool so many people for such a very long time. Madoff:

• Stacked the benefits
• Gave a lot of details
• Gave a lot of specifics
• Gave a reason why

The SEC investigators didn’t want to feel like fools. They wanted to retain the illusion that they understood Madoff’s strategies. And so, they let him continue the ponzi.

It was only in 2008 when the new money coming in was less than the old money going out, that the ponzi burst. Madoff’s own sons went to the SEC with the information that their father would be insolvent soon, when SEC finally took action. It was all too late.

Action Summary:

• Stack your claims and give multiple detailed, specific, and vivid benefits. When more information comes in that sounds good and connective, our believability metre goes up.