What can Bernie Madoff’s “magic” fund teach us about the emotions that drive our financial decisions?

What would you do if you noticed one day that your newspaper contained tomorrow’s horse racing results rather than yesterday’s?! An anomaly in the space time continuum means that you are the only person in the world who knows for sure that the 2.40 at Haydock tomorrow will be won by a 50-1 outsider.

Putting aside your incredulity, and not wishing to look a gift horse in the mouth, you spend the next 24 hours gathering as much money as possible from family and friends by generously guaranteeing to double their money. The horse wins by a nose and everyone, except the bookmaker, is both delighted and significantly better off.

The purpose of this absurdity is to set the scene for the recently released Netflix documentary about Bernie Madoff titled “The Monster of Wall Street”.

Madoff operated his “investment” fund in much the same way as our equine example, except of course that he was faced with the inconvenient truth that he was not blessed with the ability to see into the future.

Not to worry, Bernie had a solution which was to fabricate his share trades based on the previous day’s market movements. He didn’t actually invest in anything, keeping his clients’ money “safely” in the bank. The fictitious returns sent to clients were financed by the new money flowing into the fund. It was the biggest Ponzi scheme in history that lasted more than fifteen years, involved billions of dollars, and finally fell to earth with the financial crash of 2008.

What can we learn about our relationship with money from the fact that this fraudster was able to take so much money from thousands of supposedly financially literate people around the world over such a long time?

The Madoff fund offered two things that are very appealing to our psychology of money:

1. The returns that Madoff invented for his fund were cleverly positioned to be not so ridiculous as to attract the attention of regulators, but they were always significantly above the market average. For many investors the most attractive benefit was that the “fund” never lost money, even when the market was falling.

We have a natural bias to feel the negative pain of a fall in our investments much more acutely than any positive emotion we get from seeing them rise. We are very attracted to anyone who can offer us protection from this pain, and we want to believe it is possible, even if any asset manager will tell you that it isn’t.

2. The above average returns promised by Madoff were enough for many people to be seduced into thinking that they were now financially independent allowing them the luxury of choosing whether they continued to work or not. Many people were sold the dream of an early and/or comfortable retirement where their accumulated capital was able to do all the work for them.

Madoff understood perfectly how to manipulate his clients’ innate relationship with their money. Anyone who questioned his work was encouraged to take their business elsewhere. Faced with being excluded from the benefits of Madoff’s “magic” fund, very few ever did.

The series is a fascinating insight into how the flawed multiple personalities of one man (embodied by the two very different floors of his Manhattan offices from where he operated both his legal and illegal businesses) could spread around the world and inflict significant financial and emotional damage on so many people.

Above all, the story is an example of how we should always be wary of following our many natural biases that generate strong emotions around money, as they can often lead us into making poor financial decisions.

The value of investments may fall as well as rise. You may get back less than you originally invested.