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Madoff's Alleged Ponzi Scheme Scams Smart Money

RENEE MONTAGNE, Host:

Now, it may be surprising that so many people and organizations - smart people and organizations - would entrust billions of dollars to Bernard Madoff. But not everyone makes rational decisions when it comes to money. NPR's Chris Arnold reports on the psychology of investment scams.

CHRIS ARNOLD: Even people who study bad investments and financial fraud are pretty blown away by this Madoff case.

MITCHELL ZUCKOFF: It's stunning. This is both the smart money supposedly involved, which is unlike the original Ponzi, and also just the simple scale of it - $50 billion.

ARNOLD: Mitchell Zuckoff is a journalism professor at Boston University who's written a book about Ponzi schemes.

ZUCKOFF: If the allegations against him are true, what he tapped into was two strains of investor psychology. First is exclusivity. It appears that you had to be invited into these funds, and he turned away tons of people.

ARNOLD: Not everybody could be a Madoff investor. Just like not everybody could be a member of the Palm Beach Country Club.

ZUCKOFF: And the other side of it was he understood, it seems, that what people were looking for were not big hits. Big hits are suspicious and make people nervous, because if you can go up 30 percent, you can go down 30 percent. It was this metronome-like consistency - 10 or 12 percent a year, despite the ups and downs - that was so alluring to investors.

ARNOLD: That's a lot better than the overall market performs. And over the years there were some skeptics and some warnings that Madoff's returns were too good to be true. But regulators didn't catch anything, and the investors didn't ask many questions. Madoff had a great reputation on Wall Street. He was the former chairman of the NASDAQ stock market, and all that led some people to put in really unwise amounts of money.

ZUCKOFF: Putting in 90 or 100 percent of their net worth in one basket. That's shocking beyond belief.

ARNOLD: So why did they do this? Camelia Kuhnen is an assistant professor at the Kellogg School of Management. She studies something called "neurofinance," and she says there's a part of your brain at one of the centers for emotion that it turns out is very much involved in financial decisions.

CAMELIA KUHNEN: It's a very, very old part of the brain. Monkeys have them. Dogs have them. This particular part of your brain gets more activated when you perceive something potentially good for you out there in the environment, and it could be things like food if you're hungry, or water, or money.

ARNOLD: So, in other words, when you brain sees something that it really wants, your inner caveman can start to take over your decisions a little bit, especially if you start to get some encouragement and get your caveman worked up. Kuhnen says big casinos in Las Vegas seem to have figured this out.

KUHNEN: Think about how casinos are organized. When you enter the casino floor you are surrounded by cues of potential reward - you know, free food, free drinks, beautiful people walking around scantily clad. And those signs of potential reward will increase activation in the brain's reward area, which will make you take more financial risks. You're going to gamble more at the roulette table.

ARNOLD: Likewise, Kuhnen says, let's say you put some money into a Ponzi scheme or some other unwise investment. If you make some money right away, there's this very deep desire that's not coming from the most rational, more advanced part of you mind to keep plowing in more cash. Kuhnen says that this is also how bubbles happen. Whether it's buying Internet stocks, or speculating on real estate, lots of people can make very bad investment decisions or fall for scams.

MONTAGNE: Many people think that the typical victim of investment fraud is a little old widow sitting there by herself, alone. But that's not true.

ARNOLD: John Gannon is a vice president with the Financial Industry Regulatory Authority, which monitors the securities industry.

GANNON: The typical victim of investment fraud is married, college-educated, male, earning above the median income, financially literate, self-reliant.

ARNOLD: Gannon's group has done some research on financial fraud recently, but he says it hard to know really how widespread it is these days. He says, 78 percent of the victims are embarrassed and never report it. Chris Arnold, NPR News, Boston. Transcript provided by NPR, Copyright NPR.

NPR transcripts are created on a rush deadline by an NPR contractor. This text may not be in its final form and may be updated or revised in the future. Accuracy and availability may vary. The authoritative record of NPR’s programming is the audio record.

NPR correspondent Chris Arnold is based in Boston. His reports are heard regularly on NPR's award-winning newsmagazines Morning Edition, All Things Considered, and Weekend Edition. He joined NPR in 1996 and was based in San Francisco before moving to Boston in 2001.