Why Investors Fall for Ponzi Schemes

How Madoff might have charmed his investors.

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Reading the big Madoff news today might make you wonder not only how he made off with $50 billion of investors' money, but why investors fell for the scam in the first place.

It's unclear exactly how Madoff charmed these investors, but there are a handful of likely possibilities. Using telephone transcripts of fraudsters working their magic, the Financial Industry Regulatory Authority came up with five psychological tactics that are often used:

Phantom Riches. This is the classic too-good-to-be-true pitch. Think lofty interest rates on traditionally conservative CDs—as in the recent Standford case—or guaranteed double-digit returns à la Madoff. The fact is that there are few--if any--ways to get that kind of return in this market. These days, scammers prey on investors who are disillusioned by the so-called "Lost Decade" for stocks, which points to data showing that the stock market is trading below what it was ten years ago. So the promise of 8 percent to 10 percent annual returns is pretty seductive.

Source Credibility: Anyone can call himself or herself a financial planner or adviser, anyone can hang a diploma on the wall, and anyone can wear a fancy suit, so it pays to check with national organizations that issue credentials. After you make sure that the person you're dealing with is legit, you should also make sure product he or she is selling is registered with the SEC. Hedge funds are an example of an investment that's not registered. Says John Gannon, senior vice president for investor education at FINRA: "In the Madoff situation, people truly had no idea what he was doing with their money—there was the fuzzy idea that he had an algorithm to make profits, but no one had a good understanding how he was going about making money." If you don't understand how the investment generates returns, think twice.

Social Consensus: Essentially, this is when scammers use peer pressure by claiming that other investors have already invested, such as those in your social circle or perhaps your church. "Madoff had people in country clubs in Florida investing," says Gannon. Dean Barber, president of Barber Financial Group in Lenexa, Kan., says fraudsters sometimes use the allure of exclusivity: In the Madoff case, people believed because this guy had been around a long time and had some big clients." When investment frauds occur, it's often when a client signs on with a manager (financial adviser) who's also the the custodian of the account. A custodian, which would include the Fidelitys and Charles Schwabs of the world, is in possession of your investment account and issues periodic statements of transactions. The manager of assets executes those transactions. It's a good idea to keep managers and custodians separate, which ensures that all power won't fall into one person's hands.

Reciprocity: In this situation, a fraudster will offer to do a small favor in exchange for a big one. For example, a free lunch at an investment seminar may make you feel obligated to invest. Or you might be offered a break on commissions if you buy now. Bogus operators sometimes con older investors through free-lunch seminars that are followed by calls from salespeople a few days later (a common recommendation is to liquidate securities and use the proceeds to buy indexed or variable annuities).

Scarcity: If you've seen Boiler Room, you know this one. This high-pressure technique creates a false sense of urgency by claiming a limited supply. "They might tell you that there's only two units left, or that the deal is closing so they need to know today, which makes it more difficult to ask questions and check the information out," says Gannon. "There are very few deals that are so time-sensitive that you won't have the opportunity to check it out." At the very least, ask for a written explanation of the investment, and say that you'd like to pass the proposal along to a third party, such as an attorney or accountant. That's a classic turn-off for a swindler.