The psychology of falling for a Ponzi scheme
5:15 pm
Wed July 9, 2014

How to fall for a Ponzi in three steps

Six years after Bernard Madoff became a household name, people still fall for Ponzi schemes. That's probably because schemers have a tried and true method backed up by psychology. 

The Panoramic View Resort in Montauk, NY. Scammers told victims they were investing in a safe mutual fund but instead used the money in the troubled resort.
The Panoramic View Resort in Montauk, NY. Scammers told victims they were investing in a safe mutual fund but instead used the money in the troubled resort.
Credit Photo courtesy of Ed Kim

Last year there was a big, $96 million Ponzi scheme on Long Island. It had all the trappings of a Hollywood con: offshore shell companies, luxury cars, and there was even a famous beachfront resort near the Hamptons.

But for the victim there was nothing glamorous about it.

"I thought it was some run-of-the-mill fund," Jan says in a sweet Texan twang that makes friends of almost any ears.

"We thought it was a very safe investment."

Jan never got to visit the beach resort. She never got fast-talked or ever golfed with the scammer like so many of Bernard Madoff's victims. She met briefly with a "regular joe" broker at a major investment company that has its name on lots of buildings.

Bernard Madoff in March 2009.
Bernard Madoff in March 2009.
Credit AP/Louis Lanzano

But then the Securities and Exchange Commission called.

"I remember thinking 'not again'"  

This was Jan's second time in a Ponzi. Between the two scams she lost $200,000. She is embarrassed about it so she asked that only her first name be used.

Jan’s story of how she got tricked is very common and makes her a quintessential Ponzi statistic.

Just in the first half of 2014 there have at least 38 schemes totaling over $1 billion. According to Jordan Maglich, a lawyer who tracks Ponzis on his website, Ponzi cases are again on the rise with 2014 set to outpace other recent years.

Falling for a Ponzi scheme typically requires three steps.

The club with a long line

Step one is entering an aura of exclusivity.

"You want to be a part of the country club that won't have you," says Allen ​Wasserman, a lawyer who litigates against Ponzi schemers. He says the scammers always play hard to get at first.

"People would come to him and say, 'I'd like to invest with you' and he would say, 'No, I don't have enough room. I can't take on other investors.'"

Allen Wasserman, a lawyer who often represents Ponzi scheme victims.
Allen Wasserman, a lawyer who often represents Ponzi scheme victims.
Credit Charles Lane

In Jan’s case there was an exclusive investor’s conference. She says it was a small group of thirty long-term clients where brokers showed off their "exclusive" knowledge.

"They said,  'We're so smart, we know how to make money that most the people in the system don't know about.'"

Phantastic Objects

This idea of exclusivity is important because it leads to step two in falling for a Ponzi: excitement.

Or "Phantastic Objects," to borrow a term from Richard Taffler, a researcher at Warwick University in England. He studies emotional and behavioral finance which he describes as researching "the role psychology and unconscious fantasy play in investments."

Taffler says no one makes an investment decision without some level of emotion. Cold hard reason does not exist. Not even for the 52 professional money managers he studied over a one year period asking them how they felt about their portfolio decisions.

He says most investment decisions are not motivated by profit, but excitement: that investment or Ponzi scheme that only you know about.

"It's hard wired into us, that, what in reality is impossible, is nonetheless real, i.e., they can have what they want when they want it. They can rub Aladdin's lamp and just ask for what they want."

Taffler says it is linked to the early stages of neonatal development. When we were babies all we had to do was open our mouths and we were fed. When we cried these Phantastic Objects appeared from nowhere and soothed us.

What does Jan, our Ponzi victim, think of this?

"I agree with him. If you really look at it, subconsciously, it's pie in the sky, I'm gonna find the goldmine. As an entrepreneur that's what keeps me going, it's going to get bigger and better"

And good ol' gullibility

The third step in falling for a Ponzi is trust or— less politely —gullibility.

Daylian Cain, a professor at the Yale School of Management, says all of us are born gullible. His experiment for demonstrating our innate gullibility is to tell a story about the bear in the back of his Volvo.

"Not a fake teddy bear. No, a real bear. He is 888 pounds. He is huge. He is frothing at the mouth. He is tearing at my leather."

In a perfectly flat tone: "Oh wow, is he destroying my car."

The question here is not if you believe Cain and his unlikely tale. Rather, What image is in your head? An empty car or the bear in the back seat?

"The point is this: even imagining or entertaining the preposterous the brain's natural inclination is to first imagine it true. We are natural confirmation machines."

Jan, like probably most of us, pictured the bear in the back seat.

"Your mind will play tricks on you," she says. "Your mind is always going to try and go back to the safe harbor. And it's really hard to admit in the middle of a ballgame that you made a big mistake."

Could Jan, who has already fallen for two Ponzi schemes,  fall for a third?

"Oh, yeah," she says without pause.

She says anyone could fall for a Ponzi if you show them a five to eight percent return backed up with audits and statements: "I'm probably going to go 'OK, that sounds good to me.'"