The gullible’s travails

published 19 Jan 2009, MST

Intelligence and rationality are two different things. This explains why even people with high IQ can be duped.

Stephen Greenspan, PhD is emeritus professor of educational psychology at the University of Connecticut and clinical professor of psychiatry at the University of Colorado. He recently published a book entitled Annals of Gullibility: Why We are Duped and How to Avoid It after years of studying why people, even intelligent ones, fall into traps because of their gullibility. He defines gullibility as a “sub-type of foolish (or stupid) action which is induced; it always occurs in the presence of pressure or deception by other people.”

Greenspan has a related essay at the Wall Street Journal (wwww.wsj.com) and likewise at www.skeptic.com. This piece has a personal, poignant touch. Here it's not just Greenspan the psychologist speaking. It's also the same Greenspan who invested part of his retirement fund (amount has not been disclosed) in Rye Prime Bond Fund, a feeder fund that was managed by the now-notorious, self-confessed schemer, Bernard Madoff. The essay is entitled Fooled by Ponzi (and Madoff): How Bernard Madoff Made Off With My Money.

Who has not heard of Madoff by now? He's the 70-year-old fellow who might pass for Santa Claus but has brought anything but gifts and good tidings. The founder of Bernard L. Madoff Investment Securities (which he put up in 1960) was arrested last month for securities fraud. He is now on house arrest at his luxurious penthouse in New York City.

We know that Madoff's clients were mostly high-profile institutions, charities and individuals, and that investing with him was purely by invitation only. He himself said he had duped his clients to the tune of $50 billion. Many of his clients' fortunes and reputations crumbled; a French aristocrat who had been doing business with and on behalf of Madoff committed suicide before Christmas.

What many of us don't know is that as early as 2005, somebody by the name of Harry Markopolos wrote the US Securities and Exchange Commission citing 29 red flags in Madoff’s activities. The SEC did conduct an investigation and found nothing. There were also reputable audit firms that looked at Madoff's business, but “KPMG, PricewaterhouseCoopers, BDO Seidman and McGladrey & Pullen all gave clean bills of health to the numerous funds that invested with Bernard Madoff and his asset-management firm,” Time Magazine said.

That Madoff was able to keep his show running for decades is a feat. Why has he gotten away with all this? Why did it take massive redemptions due to the financial crisis (people needed their money) to expose he had nothing after all? How was he or his representatives able to sway a psychologist studying people's gullibility (Greenspan), a pessimistic Wall Street economist (Henry Kaufman, also known as Dr. Doom) and many other people you'd expect to know better and convince them to trust him with their money? Is Bernie Madoff a psychological genius?

**

A sobered Greenspan says that in Ponzi schemes, investors who wish to redeem their money are actually paid out of proceeds from new investors. “As long as new investments are expanding at a healthy rate, the schemer is able to keep the fraud going. Once investments begin to contract, as through a run on the company, the house of cards quickly collapses.”

For many years, that Madoff's house was one of cards was not apparent. He had a record of payouts that, while deemed relatively modest at 10 to 17 percent were steady (they were later on described as unnaturally consistent.) They were big enough to entice clients but not too big as to arouse suspicion from regulators. This, according to Greenspan, helped conceal the irregularity in Madoff's activities. The truly greedy people, looking for higher returns, would not have paid any attention to the offer.

The financial scheme, i.e., how the funds are supposed to make money, is also difficult to understand. The language used to convey the how-to of the funds sounds too sophisticated to non-financial experts so that the only validation available is how other people have thus far responded (i.e., positively) to the invitation and how steadily they have made their money. Greenspan himself admits that at one point, even he felt that it would be silly not to invest and hence pass up this great opportunity.

Madoff knew how to stroke egos. One cannot be a walk-in investor; one had to be invited. As a result, people became more agreeable and receptive knowing that not all were induced to participate in the fund. They were probably tickled pink at the thought.

Finally, Madoff was known for his philanthropic activities. Maybe the do-gooder factor helped quash any doubts -- “no, he couldn't possibly do something bad.”

And yet, as the world now knows, he could.

**

In his book, Greenspan offers a multi-dimensional theory that defines a person's gullibility -- the factors of situation (a person is presented with a social challenge he has to solve), cognition (laziness to be skeptical and reliance on others' behavior), personality (trust and nice-ness accompanied by an occasional tendency towards risk-taking and impulsive decision-making) and emotion come into play.

Actually, the interplay is not just true for making financial decisions. Gullibility is seen in many facets of life: in war, politics, relationships, medicine.

Still, Greenspan's bravery to come forward and embrace his own gullibility is noteworthy, given his stature and authority in his field of expertise -- even though towards the end of the essay, he gets defensive and says there must be a little skepticism left in him since he only invested a third of his retirement fund with Madoff.

Some lessons are learned vicariously. That goes for the rest of us who only read about these things and, at most, empathize – or blame. Some, however, have to be educated the painful way. I said earlier on that Greenspan identified gullibility as a sub-type of stupidity. But it comes as no surprise that there should be a higher form of stupidity that applies to all, expert or dull, rich or poor, man or woman – forgetting these lessons altogether and being gullible yet again.