In his classic detective story The Purloined Letter, Edgar Allen Poe tells how an embarrassing letter has been stolen (purloined) from the French Queen to be used for blackmail. The authorities believe they know who took it, and order a thorough search of his apartment. The police detectives pull up the carpet, probe seat cushions with needles, and even look behind the wall paper. But they fail to find the letter.
In comes Poe's protagonist, amateur detective August Dupin, who quickly finds the letter and turns it in to the authorities. When asked how he succeeded where the professionals failed, Dupin says that he knows the suspect to be a very shrewd man and so would have hidden the letter in the one place nobody would look—in plain sight. He had simply refolded it and placed it on top of some old correspondence.1
Bernie Madoff used this same strategy to conceal the largest Ponzi scheme in history, taking in nearly $65 billion over two decades.2 Arrested in 2008, he was serving a 150-year prison sentence when he passed away earlier this year. (A Ponzi scheme is a financial scam where participants are told their money is being legitimately invested, but their dividends are paid from the deposits of later investors.)
Madoff's death occasioned a reexamination of how so many people who should have known better entrusted him with millions of their dollars.
John Authers, senior writer for Bloomberg and The Financial Times, identifies several things Madoff did to avoid detection:3
Consistency was his distinction - He never promised outrageous returns, just 10% year in and year out.
The Establishment was the perfect cover - Madoff was a respectable Wall Street figure who had held prominent positions.
Exclusivity drove demand - His victims felt lucky to get in.
Authers writes, "Madoff did not advertise his scheme. And he had a well-practiced schtick of telling friends who asked if they could buy into his funds that they were full and that there was nothing he could do for them." He would later relent and say he'd found a way to get them in.
Madoff succeeded in part by promising people the one thing every investor desires: consistency. He was offering inflation-beating returns with the apparent safety of a CD.
But his investors were knowledgeable enough to know better. A fund that seems to violate the law of returns-requiring-risk should have been a red flag.
Prudent investors know that there is no such thing as a free lunch. Pursuing inflation-beating returns requires an unwavering commitment to an unknowable future that is anything but consistent. So rather than believing that a fund manager can consistently outsmart the market, they will hold a broadly diverse portfolio with the understanding that volatility will likely be a constant over their investing lifetime.