I find the epic Ponzi scheme of Bernard Madoff morbidly fascinating. He managed to lose 50 billion dollars, which can’t be easy:
A busy stock-trading operation occupied the 19th floor, and the computers and paperwork of Bernard L. Madoff Investment Securities filled the 18th floor.
But the 17th floor was Bernie Madoff’s sanctum, occupied by fewer than two dozen staff members and rarely visited by other employees. It was called the “hedge fund” floor, but federal prosecutors now say the work Mr. Madoff did there was actually a fraud scheme whose losses Mr. Madoff himself estimates at $50 billion.
For years, other investors looked at Madoff’s steady market returns with suspicion – they seemed too good to be true. No matter what happened to the market, Madoff found a way to earn around 10 percent. Of course, we now know how those returns were achieved: with straight up lies.
The larger story, though, is the mistaken belief that allows frauds like Madoff to exist in the first place: our assumption that the market average can be consistently beaten, if only we entrust our money to the right person (or the right algorithm). This is why people rush to invest with the hottest mutual fund managers and are perfectly happy to hand over 20 percent of their profits to a hedge fund. But this belief is false. The market, after all, is a classic example of a “random walk,” since the past movement of any particular stock cannot be used to predict its future movement. This inherent randomness was first proposed by the economist Eugene Fama, in the early 1960′s. Fama looked at decades of stock market data in order to prove that no amount of rational analysis or knowledge (unless it was illicit insider information) could help you figure out what would happen next. All of the esoteric tools and elaborate theories used by investors to make sense of the market were pure nonsense. Wall Street was like a slot machine.
I discuss this illusion in my forthcoming book, where I look at silly investor behavior through the prism of our dopamine neurons, which are determined to find rewarding patterns even when no pattern exists:
The lesson here is that it’s silly to try to beat the market with our brain. Dopamine neurons weren’t designed to deal with the unpredictable oscillations of Wall Street. When we spend lots of money on investment management fees, or sink our savings into the latest hot mutual fund, or pursue unrealistic growth goals, we are slavishly following our primitive reward circuits. Unfortunately, the same circuits that are so good at tracking squirts of apple juice will fail completely in these utterly unpredictable situations. “People enjoy investing in the market and gambling in a casino for the same reason that they see Snoopy in the clouds,” says Read Montague. “When the brain is exposed to anything random, like a slot machine or the shape of a cloud, it automatically imposes a pattern onto the noise. But that isn’t Snoopy, and you haven’t found the secret pattern in the stock market.”
That’s why a randomly selected stock portfolio will, over the long run, beat the expensive experts with their fancy computer models. Or why the vast majority of mutual funds in any given year will underperform the S&P 500. Even those funds that do manage to beat the market rarely do so for long. Their models work haphazardly; their success is inconsistent. Since the market is a random walk with an upward slope, the best solution is to pick a low-cost index fund and wait. Patiently. Don’t fixate on what might have been or obsess over someone else’s profits. Investors who do nothing to their stock portfolio – they don’t buy or sell a single stock – outperform the average “active” investor by nearly 10 percent. Wall Street has always searched for the secret algorithm of financial success, but the secret is that there is no secret. The world is more random than we can imagine. That’s what our emotions can’t understand.