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While considering possible topics for this week’s ‘blog,’ it was hard to ignore the Madoff investment scandal.  The scope of Mr. Madoff’s fraud is almost incomprehensible in terms of the hundreds of people and organizations that have been impacted.  That he was able to defy detection for several decades, in spite of numerous government investigations, is unbelievable given the intense scrutiny with which the SEC conducts its audits of investment advisory firms including Moneta Group.  Although I found the whole saga interesting, in my world, major headline scandals rarely make my ‘radar screen’ as life changing events.

Today, however, reading the St. Louis Business Journal, I discovered that some charitable organizations in St. Louis will likely discover that a portion of their endowments were indeed invested indirectly in funds managed by Mr. Madoff.  My initial and somewhat indignant reaction centered on one question: How could one person be so greedy as to actually take money from charities and knowingly invest in a fraud?  In the Business Journal article, one of those interviewed noted that exposure to any one fund is relatively low because most endowments invest in multiple subsidiary funds.  Another quote said that, “a cornerstone of [their] investment policy is to maintain a portfolio that is well-diversified across asset classes and managers.”  Wow! I never imagined that another reason to maintain a diversified portfolio, a strategy constantly advocated at Moneta, could be necessary to protect your portfolio from unscrupulous money managers!

Still adhering to my (sometimes naïve) Midwestern values, I can’t help but wonder about the investors who were persuaded to invest most, if not all, of their net worth in these funds.  The headlines are rife with examples of highly educated, market-savvy people who were blindsided by Mr. Madoff’s fraud.  One possible explanation is discussed in a new book, Annals of Gullibility, by Stephen Greenspan (apparently no relation to the infamous Alan).  A recent article by the author in the Wall Street Journal describes the book’s premise as:

“…a multidimensional theory that explains why so many people behave
in a manner that exposes them to severe risks in spite of danger signs
and unresolved questions.”

In the article, a very persuasive logic is outlined explaining why people fall for such scams.  The most powerful point presented is that even the author, an emeritus professor of educational psychology, fell for the Madoff scam.  But fortunately for him, the power of portfolio diversification was his ‘safety net,’ resulting in a loss of only a portion of his total investable assets.

I plan to add Annals of Gullibility to my reading list for 2009, as part of my education into the psychology of decision making.  Over the years I have seen that it can be hard for clients to maintain the discipline of a diversified portfolio when one or two investment sectors are outperforming the others. And although diversification did not provide any hiding places in 2008, the argument for maintaining this strategy still stands: Diversification is a necessary component of any investment plan going forward.

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Ann Rackers, MBA Ann Rackers is the professional consultant for Steve Finerty and Linda Pietroburgo.