The man who is admired for the ingenuity of his larceny is almost always rediscovering some earlier form of fraud.

—John Kenneth Galbraith

Jason Statham has appeared in over 40 major motion pictures, which have grossed upwards of $1 billion in ticket sales. The British actor has a penchant for action movies, appearing in a handful of the Fast & Furious movies, The Expendables franchise, and a plethora of other films with extended fight scenes, car chases, and stuff getting blown up. I’m partial to his early work in his roles as Turkish in Snatch and Bacon in Lock, Stock and Two Smoking Barrels, both Guy Ritchie movies, but movie fans obviously enjoy his work.

While Statham is known as an action movie star, he is most certainly not known for reaching out to fans of his movies on Facebook and asking them for money. A woman in England told the BBC she lost a fortune after being contacted on a Fast & Furious fan page on the social media site by a man claiming to be Statham. The two sent hundreds of messages back and forth to over the next several months, leading the woman to believe she’d built a solid relationship with the well-known movie star.

So when he told her he was having financial difficulties, claiming he needed a bridge loan until a movie paycheck cleared, she was more than happy to help out by sending cash his way. The woman made a series of payments that cost her hundreds of thousands of pounds. Of course, the person she was talking to online was not Jason Statham. The authorities never were able to track down who defrauded this poor woman but they think it was someone from overseas.^[1]

I know what you’re thinking: How could someone be this gullible?! It seems beyond the realm of possibilities that a bona fide movie star would ever befriend random strangers on the Internet, only to later ask them for money once an online relationship is established. Unfortunately, we’re all gullible in our own way.

Psychologist Stephen Greenspan is an expert on human gullibility and why we’re so easily persuaded into believing things that just aren’t true. Greenspan says a gullible outcome is the result of the interaction between four factors:

1. The Situation. Certain situations can exert tremendous tremendous social pressure from family, friends, or the investing public to act. Peer pressure is how bull markets and seemingly good ideas turn into manias, forcing people to jump into the fray even when it seemingly makes no sense.
2. Cognitive Processes. Everyone has their own blind spots. For some that means not knowing enough to make an informed financial decision. For others that means becoming overconfident in their ability to pick winning investments. Still others can’t see the obvious fraud that’s staring them right in the face because they want so badly to believe it’s true.
3. Personality. Some people are impulsive with their money. They’ll spend more time researching the reviews for a $7 purchase on Amazon than they will when making $50,000 investments with their life savings. Others are far too trusting when it comes to money matters.
4. Emotional State. Emotions are neither good nor bad; they just are and they make us human. But your emotional state when making big-time decisions can impact your ability to see things clearly. This is especially true when dealing with important financial decisions.

Greenspan penned an entire book on the subject called The Annals of Gullibility: Why We Get Duped and How to Avoid It. He explains gullibility is not only the tendency to be duped or taken advantage of but a “pattern of being duped, which repeats itself in different settings, even in the face of warning signs.” In the introduction to the book Greenspan listed personal reasons for writing such a book beyond sharing his research with the world at large, admitting he himself was “unusually gullible as a child, and still continue[s] to have gullible moments as an adult.”

The Annals of Gullibility was released in December 2008 during the height of the Great Financial Crisis, the worst economic meltdown since the Great Depression. The US stock market fell nearly 40% in 2008 alone. As is the case with many of the frauds profiled throughout this book, when the rug got pulled out from under the markets and the economy was in the toilet, all sorts of financial frauds and charlatans came to light that had been masked for years. There is no greater fraud or charlatan in modern financial history than Bernard L. Madoff. Madoff swindled banks, hedge funds, wealthy investors, celebrities, and charities with his $65 billion Ponzi scheme, which finally came crumbling down that very same December after decades of lies and deceit.

There were plenty of big-name investors who were fooled by Madoff’s scheme – Steven Spielberg’s foundation; actors Kevin Bacon, Kyra Sedgwick, and John Malkovich; hall of fame pitcher Sandy Koufax; Forrest Gump screenwriter Eric Roth; talk show host Larry King; movie producer Jeffrey Katzenberg; and New York Mets’ owner Fred Wilpon.^[2]

Oh yeah, there was one more person of interest who was invested in Madoff’s fund – our gullibility expert Stephen Greenspan. That’s right, the guy who literally wrote the book on how gullible we are as a species was a victim of the biggest Ponzi scheme in history, losing a substantial amount of his retirement savings in the process. Greenspan’s life’s work on the subject just so happened to be released the very same month Madoff’s fraud fell apart. Truth really is stranger than fiction sometimes.

In the things-that-did-not-age-well section of his book, Greenspan concluded, “Because gullibility resistance increases as a function of wisdom acquired in the course of human experience, I am optimistic about my own, and others’ ability to become less gullible. As one accumulates experience with people, their schemes, and their foibles, one can acquire the ability to recognize some idea or proposed action as possibly unwise. The ability to hold off being influenced by someone selling a false notion is an ability that can, I think, increase with age and experience. Obviously, that will not always be the case, especially where there is cognitive impairment or where the social pressure is too great or where a scheme calls forth a strong emotion (such as greed) or where the victim has a personality in which dysfunctional schemas are too entrenched and where there is, consequently, an inability to learn from past mistakes.”^[3]

Many people at the time used Greenspan as a punch line for how gullible people can be with their finances and it does make for quite the narrative. But he was generous enough after the fact to share his story about how even an expert on getting duped could himself get caught up in the biggest Ponzi scheme ever concocted. Greenspan was a good sport about the whole ordeal in what must have been a difficult time for him both professionally and financially. In a piece he penned for the Wall Street Journal shortly after this became public, he explained:

In my own case, the decision to invest in the Rye fund reflected both my profound ignorance of finance, and my somewhat lazy unwillingness to remedy that ignorance. To get around my lack of financial knowledge and my lazy cognitive style around finance, I had come up with the heuristic (or mental shorthand) of identifying more financially knowledgeable advisers and trusting in their judgment and recommendations. This heuristic had worked for me in the past and I had no reason to doubt that it would work for me in this case.^[4]

Greenspan also cited trust as one of the biggest issues in why so many chose to invest with Madoff. A close family friend who was an advisor seemed trustworthy enough and came highly recommended. The guy was likeable, persuasive, and had even put the majority of his own net worth into Madoff’s fund, which sold Greenspan on the investment. Other investors shared their positive experiences with the advisor and the fund. So when a friend warned him that something seemed off about this investment opportunity, Greenspan assumed this detractor was merely being cynical. Certainly the performance numbers for Madoff’s fund seemed too good to be true, but too good to be true tends to work better when thinking about others, not ourselves. Nah those numbers are too good to be true. But what if they aren’t? Why shouldn’t I be the one to discover the secret sauce, the Holy Grail, the easy road to riches? I deserve this.

Greenspan wrote, “While as a rule I tend to be a skeptic about claims that seem too good to be true, the chance to invest in a Madoff-run fund was one case where a host of factors – situational, cognitive, personality and emotional – came together to cause me to put my critical faculties on the shelf.” Money has a way of clouding the brain and putting all of our critical faculties on the shelf when we start adding up the potential returns in our head. We all think we’re special and deserving of extraordinary investment opportunities.

Psychologists call this the Barnum effect. Studies performed in the 1940s and 1970s had experimenters in white lab coats administer personality tests and then hand the subjects a report afterwards to show them their results. What the subjects didn’t realize is every report was exactly the same, regardless of the personality test scores. The fake reports contained a long list of results about underlying character, personality traits, and behavioral makeup. Next these subjects were asked to comment on the accuracy of the reports. They were asked to rate the accuracy of the results on a scale of 1 to 5. The average score of was 4.3. Not only were the personality test results made up, Bertram Forer, the researcher who performed the original test, said he put together the reports from a series of horoscopes and astrology readings. So everyone assumed they received unique personality results, but the reports were so generalized they applied to nearly everyone who read them. This is why people believe their horoscopes are eerily accurate. It’s not voodoo but common sense. It’s also why your own assessment of yourself can be wildly inaccurate at times.^[5]

Self-deception becomes even more effortless when groupthink is at play. We often look to others to figure out what the correct behavior should be, especially when dealing with financial matters. We follow the crowd or the narratives instead of what the evidence or common sense would dictate. It feels more comfortable to go along with the crowd when making tough decisions because we look to others during times of uncertainty. When we see other people making profits that’s a green light in our brains that we deserve some of those winnings. Other people making money almost always make it seem too good to pass up. One of the main reasons we humans fall for this stuff time and time again is we fail to understand the sacred relationship between risk and reward.

Ponzi versus Bernie

Bernie Madoff ran a pyramid scheme, paying out legacy investors in his fund using cash inflows from new investors. As we learned earlier in the book about the airplane game, this is the type of strategy that works until it doesn’t because you need an endless supply of new investors to keep the house of cards standing. Maybe the most impressive (or saddest) thing about the whole Madoff scandal is the fact that it was ever able to grow to the size that it did at $65 billion. The size and scope of his deception makes me wonder: If it wasn’t for a certain Italian-born scam artist in the 1920s, might we call the kind of scam Bernie pulled off the Madoff scheme from now on?

I would be remiss if I spent an entire book discussing the history of financial scams without mentioning the godfather of the genre who has the honor of having his very own fraudulent strategy bear his surname. Madoff actually started out his career in a legitimate way, but Charles Ponzi began as a lowly con man forging checks in Canada. This led to a short prison stint that didn’t reform the man but made him an even better scam artist. After serving time in the clink Ponzi discovered a system that allowed people to purchase coupons that could be used to buy stamps in other countries. Because currencies can fluctuate wildly from country to country Ponzi saw an opportunity to use these coupons to profit. The idea was to buy stamps in a country with a collapsing currency and redeem them in a country with a strong currency. Buying up a bunch of these stamps at wholesale could lead to a huge profit, assuming you could actually pull off this trade and time it correctly.^[6] To make the business sound legitimate, Ponzi claimed to have a network of buyers throughout Europe to facilitate the trades.^[7]

Despite his shady financial background, Ponzi opened up a firm called the Securities and Exchange Company to raise money from investors. The pitch to clients was just a tad ambitious. Prospective investors were promised 40% on their original investment after just 90 days! That’s not bad considering the prevailing interest rate at the time was just 5%. Forty percent every three months would be an annualized return of almost 285%. Earning 57 times the risk-free interest rate is a pretty good deal if you can get it. Even more investors gave Ponzi money when he upped the ante by offering 90-day notes that would double your money or 50-day paper that would give investors a 50% return on investment.^[8]

Once he paid off his first round of investors, people were hooked and the news spread as far and wide as a Kim Kardashian Instagram post. Ponzi was pleasantly surprised to find around 40,000 people sent him money to the tune of $15 million. And most of these initial investors didn’t require a withdrawal because so many of them simply rolled their “profits” into another investment with their financial mad scientist.^[9] People entrusted a 34-year-old ex-con with millions of dollars based on false promises alone. The 1920s were such a magical time people believed almost anything. Investors ranged from rich politicians to poor immigrants to a priest.^[10]

So much money poured in Ponzi barely knew what to do with it, considering his stamp scheme never had a snowball’s chance in hell of working. Cash and banknotes piled up from floor to ceiling as naive “investors” assumed they could earn the easiest money on the planet. Ponzi was forced to hire six clerks just to help him keep track of all the money that came in. There was so much cash they had to store it in trash baskets. Because the scheme he purported to run was never realistic in the first place, all this cash made Ponzi fabulously wealthy. He hired a car and chauffeur and walked around town with a gold-tipped cigarette holder.^[11]

Luckily, not everyone was so entranced by Ponzi’s promises of free money. The Boston Post did the math on his stamp idea and realized it was impossible to pull off at scale using some simple back-of-the-envelope math. There weren’t enough coupons in existence to pull off Ponzi’s claims. After reading the story an angry mob showed up at the SEC offices demanding their money back. Initially, everyone was paid with interest, as Ponzi assured investors there was nothing to worry about (which is exactly what a charlatan would say). He claimed the newspapers didn’t know what they were talking about and that he had another secret way of making money. The original plan was merely a decoy. The crowd relented and actually handed the huckster even more money that day.

Finally the district attorney stepped in, demanding an audit of his books, which led to a run on the pyramid scheme. Things got so bad the glass door to his office broke and people were injured. The next week the papers interviewed a former partner of Ponzi’s who said the con man was “as crooked as a winding staircase” and in debt to the tune $4 million. Reporters also asked why Ponzi put his own money in 5% bank deposits if his strategy was making 50% every 45 days? Why wouldn’t he eat his own cooking if it was so good? Such was the man’s hubris that he actually blamed the banks and tried to sue the newspapers. Finally, someone tracked down a mug shot from Ponzi’s lowly con artist days in Canada just as the auditors revealed the entire operation was a sham.

Ponzi never even bothered buying the stamp coupons in the first place, instead paying off legacy investors with new money that was flowing in. Somehow the operation was still an estimated $3–7 million in the hole. Ponzi went back to jail but spent less than four years behind bars before heading to Florida to give it one more try, where he was almost immediately sentenced to jail for real estate fraud. This time he promised 200% to investors in just 60 days. He was eventually deported back to Italy, where he lived out his life in a state of poverty.^[12]

The Sacred Relationship

Every successful investor must understand there is a sacred relationship between risk and reward. There is no proven way to earn a high return on your capital without taking some form of risk nor is it possible to completely extinguish risk from your investments. At best you can trade one risk for another because it never really goes away. From 1928 through 2018 the US stock market returned 9.5% annually. That’s good enough to double your money every seven to eight years. Ten-year treasuries, bonds issued and guaranteed by the US government, returned 4.8% per year over this same time. Cash, as proxied by three-month US treasury bills, returned 3.4%.

In the hierarchy of asset classes, stocks should return more than bonds and bonds should return more than cash over the long haul. Of course this isn’t always the case depending on how you define “long-term,” but this should be your baseline for setting expectations. However, investing in the stock market is not free money. You have to pay your tuition to earn those higher returns. Although the long-term returns have been in the 9 to 10% range, the annual returns are rarely close to those long-term averages.

In fact, in the 91 years from 1928–2018, there were a grand total of three years where the market finished a calendar year with returns in the 9 to 11% range. Stocks tend to earn higher long-term returns than bonds or cash because (a) they can be highly volatile in the short term and (b) they have a higher risk of large losses. When stocks are up in a given year, they’re typically up big, and when stocks are down in a given year, they’re typically down big. The S&P 500 has experienced positive returns in 66 years since 1928, meaning it was down in the 25 remaining years. When the stock market was up, the average return was close to 21%. And when it was down, the average return was close to negative 13%.

Double-digit returns are the norm in the stock market. Of those 66 positive annual returns, almost 80% of the gains were double-digit up years while almost half were gains of 20% or higher. Almost half of all down years saw double-digit losses while six calendar years experienced losses in excess of 20%. On the other hand, bonds were down in just 18% of all calendar years, meaning they saw positive returns roughly four out of every five years. And the worst loss for 10-year treasuries was just 11% in a single year. The stock market has been down more than 30% in three different years. Cash has never had a down year.

Why am I telling you all of this? Because any investor needs to understand that volatility and losses are the price of admission if you wish to earn higher returns on your money. If you crave safety and stability, you’re going to be forced to accept lower returns, or take much greater risks than you realize to earn those stable returns in cash-like investments. Risk and reward are attached at the hip, and anyone who tries to skirt this relationship is almost sure to end up regretting that decision.

Ponzi went straight for the jugular by preying on the greed that existed in the 1920s, but Bernie Madoff never promised outlandish returns. Instead, Madoff focused on our inherent aversion to loss and volatility. Our resident gullibility expert Stephen Greenspan explains:

A big part of Mr. Madoff’s success came from his apparent recognition that wealthy investors were looking for small but steady returns, high enough to be attractive but not so high as to arouse suspicion. This was certainly one of the things that attracted me to the Madoff scheme, as I was looking for a non-volatile investment that would enable me to preserve and gradually build wealth in down as well as up markets.^[13]

The markets are controlled by two main emotional responses: fear and greed. Ponzi clearly went for the latter by marketing to the seemingly endless supply of greed that existed at the onset of the roaring 20s. There will always be a market for suckers who get taken in by get-rich-quick schemes for the simple fact that a shortcut to wealth is much more appealing than the long game. In January 2009, just a month after Madoff’s scandal was splashed across the headlines, a man named Nicolas Cosmo was charged by the CFTC for defrauding investors out of tens of millions of dollars. Cosmo promised his investors out-of-this-world returns of 50% per year. Much like Ponzi, Cosmo had previously been arrested for fraud but instead of going clean he opted to go for a bigger fraud the next time out.^[14]

The reason Madoff’s scam lasted so much longer than Ponzi’s stamp fraud is that he wasn’t promising to double people’s money overnight. This was a more deliberate scam with the return numbers he falsified. Bernie Madoff preyed on people’s fears and our inherent aversion to loss. Loss aversion is the idea that losses sting twice as bad as gains make us feel good. There’s an entire literature of behavioral psychology research on the topic, but Andre Agassi explains this idea beautifully in his book, Open: An Autobiography, when discussing the difference between winning and losing on the biggest stage in professional tennis:

But I don’t feel that [winning] Wimbledon changed me. I feel, in fact, as if I’ve been let in on a dirty little secret: winning changes nothing. Now that I’ve won a slam, I know something that very few people on earth are permitted to know. A win doesn’t feel as good as a loss feels bad, and the good feeling doesn’t last as long as the bad. Not even close.^[15]

Bernie’s genius was promising returns of 10% to 12% year in and year out, something stock market investors would kill for. The made-up consistency of his investment returns even translated into his golf scores. Madoff always reported scores of between 80 and 89 for every round he played. Fraud was simply in this guy’s DNA.^[16] Reported numbers from one of the feeder funds that invested with Madoff shows just how unrealistic his reported performance numbers were. Over the course of 18 years, the fund earned nearly 11% per year, a decent return to be sure but not necessarily a grand slam. The eye-catching number is the reported volatility of this fund, which was just 2.5% with zero annual losses. To put this into context, the long-term volatility of the US stock market is roughly eight times higher than this. And not only were there no annual losses reported but nary a down quarter and just a few down months of performance.^[17]

Madoff was promising all of the returns in the stock market with none of the risk. It’s no wonder his investors never asked any questions. They assumed they’d hit the jackpot. So while his defrauded investors weren’t greedy in the traditional sense, they were trying to skirt the sacred relationship that exists between risk and return by earning consistently high returns with very little volatility or loss. Bernie himself said, “Everyone was greedy. I just went along.”^[18]

Understanding the relationship between risk and return goes far beyond avoiding frauds and Ponzi schemes. Wall Street makes lots of money offering false promises that they can contain or completely eliminate risk from your portfolio. Risks can change shape but they never completely go away. If you wish to earn higher returns on your investments, occasionally you are going to have to suffer mind-numbing losses. If you wish to minimize mind-numbing losses on your investments, occasionally you are going to have to miss out on face-ripping gains. This is how risk and reward work. To those who think they have what it takes to break the bonds of this risk-reward relationship, to quote Jerry Seinfeld, “Good luck with all of that.”