LET'S REMINISCE: Ponzi schemes, other human errors

By Jerry Lincecum
Special to the Herald Democrat

The recent death of Bernard Madoff, who was the mastermind behind a $20 billion Ponzi scheme – the largest financial fraud in history, prompted me to contemplate some examples of what might be called “stupid human errors.”

Go to any grocery store and you’ll see examples of what behavioral-pricing researchers refer to as “the left-digit bias.” When an item is priced at $2.99, the idea is that consumers will think of it as $2.00. That’s because the mind compares the left-most digits before it can round up the numbers. People look left first.

Recent experiments found that when consumers see a jar of peanut butter by itself for $2.99, in their minds they round the price up to $3.00. But that’s not true when two jars of peanut butter are displayed side by side. When participants in this experiment were shown a premium brand priced at $4.00 alongside the store brand priced at $2.99, their minds compared the left-most digits first, before rounding any numbers. So they thought the store brand was $2 less than the premium brand.

Now let’s consider stupidity on a bigger scale. It was little more than a hundred years ago that the original Ponzi scheme was put in operation. It started because investors were concerned about the huge amount of international debt left over from World War I. Beginning in 1919, Charles Ponzi, a Boston banker, offered to pay investors, within 45 days, $150 for every $100 they lent him. The immigrant from northern Italy credited this spectacular promised return on investment to trading in international postal coupons.

Word spread that anyone could earn a huge profit just by placing their money with Ponzi. An article in the Wall Street Journal said, “Give Ponzi a million and in a twelvemonth he will expand it for you to some $25,000,000; in two years to $657,000,000. Surely the Allies could spare him a million, and within three years clean up that debt tangle.”

However, it wasn’t long before Ponzi’s scheme began to unravel, and his firm was the target of a massive run, with hundreds of once-eager investors lined up to try and retrieve their money. The state soon closed Ponzi’s bank, and then a federal grand jury charged him with fraud.

In a classic Ponzi scheme, a con artist offers investors outsize returns based on an intriguing moneymaking venture. Earnings are hard to verify, but nobody much cares because the business seems to produce such big payouts. Rather than using investments to produce profits, however, the con artist simply pays off earlier investors with money just arriving from later ones. These earlier investors find the returns so compelling that they often let their earnings ride and grow.

Bernard Madoff had a legendary career on Wall Street, famously delivering astronomical returns for his investors, which included a number of celebrities. He served as chairman of the Nasdaq American stock exchange in New York for several years in the 1990s and amassed beach houses, boats and a Manhattan penthouse. But in 2008 Madoff was arrested and in 2009 he pleaded guilty to eleven felony charges. In classic Ponzi fashion he had been using money from new

investors to pay back earlier investors. He claimed to have a total of $65 billion under management, but two thirds of that money was a figment of Bernie Madoff's imagination.

In his guilty plea, Madoff admitted that he hadn't actually traded since the early 1990s, and all of his returns since then had been fabricated. He was a "master marketer" who, throughout the 1970s and 1980s, built a reputation as a wealth manager for a highly exclusive clientele. Investors who gained access, typically on word-of-mouth referral, believed that they had entered the inner circle of a money-making genius.

People who met him in person were impressed with his apparent humility. Madoff was sentenced to 150 years in prison, and recovery of funds from the investment scandal eventually returned more than $14 billion to the defrauded investors. He died at 82 after serving only twelve years of his sentence.

Jerry Lincecum

Jerry Lincecum is a retired Austin College professor who now teaches classes for older adults who want to write their life stories. He welcomes your reminiscences on any subject: jlincecum@me.com.