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  By Guest Blogger Doug Rowat

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As his decades-long, US$68 billion Ponzi scheme famously made clear, Bernie Madoff was perhaps the vilest fraudster in Wall Street history.

However, his investors still bear some of the blame for their own downfall. Few questioned the incongruously spectacular performance of their investments. Such considerations were unpleasant. Much better to continue under the illusion of phenomenal gains, no matter how improbable.

A casual examination of their client statements might have revealed how inconsistent their returns were relative to the broader market. But there was other evidence being presented that created even clearer doubt. Journalist Michael Ocrant was a long-time Madoff critic who aired his concerns publicly in an article published in 2001—seven years before Madoff’s empire collapsed:

…most of those who are aware of Madoff’s status in the hedge fund world are baffled by the way the firm has obtained such consistent, nonvolatile returns month after month and year after year.
…among other things, they also marvel at the seemingly astonishing ability to time the market and move to cash in the underlying securities before market conditions turn negative; and the related ability to buy and sell the underlying stocks without noticeably affecting the market.
In addition, experts ask why no one has been able to duplicate similar returns using the strategy…

What we witnessed with Madoff investors was the ‘ostrich effect’, a behavioural bias that suggests investors ignore negative information because it creates psychological discomfort.

Researchers Dan Galai and Orly Sade in 2006, for example, determined that investors were more willing to make investments if the level of risk went unreported, hence the idea that investors prefer not to deal with unpleasant realities. If one can’t see the negative information, it doesn’t exist.

The ostrich effect, of course, wasn’t just limited to Madoff investors. More significantly, it also applied to the SEC, the regulatory body tasked with actually protecting the public. By 2005, Ocrant was getting far more direct with his criticism of Madoff’s firm. His presentation to the SEC in 2005 should have left no room for doubt:

Madoff: the signs were there

Source: SEC.gov

But, as we know now, the heads at the SEC remained buried in the sand.

The ostrich effect, of course, doesn’t just apply to epic Wall Street Ponzi schemes, it also applies to investors’ personal finances in more subtle, but still harmful, ways.

We see the ostrich effect play out in our own practice mainly as it pertains to excessive client spending or poor household budgeting.

Sometimes clients are unaware that their spending is significantly eroding their portfolio principal, for instance, and it becomes our responsibility to point this out. In many cases, clients react emotionally to this information, marked by a desire to either change the subject or an outright refusal to acknowledge that their spending is jeopardizing their finances at all. The underlying impulse, of course, is to prevent the introduction of information that threatens their current (and pleasurable, I might add) spending habits. But denying that there’s a problem only offers temporary relief from reality.

So, how best to increase awareness of, and limit the impact from, the ostrich effect?

First, and very straightforward tactic to build awareness, note when you tend to log in to your investment accounts. Investors who log in more often when markets are strong are in the grip of the ostrich effect. A 2009 paper from researchers Niklas Karlsson, George Loewenstein and Duanne Seppi, showed that investors were far more likely to look up their accounts during periods when S&P 500 returns were positive versus negative:

Investors prefer to check their portfolios only when the market is doing well

Source: Karlsson et al. S&P 500 return categories vs Vanguard account long-ins. Sample period is Jan 2, 2006 to June 30, 2008

So, when you log in to your accounts, note the prevailing market conditions. If the pattern resembles the chart above, then your behaviour is being governed by the ostrich effect.

Second, the ostrich effect often manifests itself in a refusal to monitor one’s financial progress, namely not booking or showing up for portfolio reviews. Simply put, clients don’t want to encounter feedback that might signal that their financial future’s in trouble. My bet is that these individuals also avoid scheduling doctor’s appointments to, similarly, avoid confronting other potentially bad news. So, book and keep your appointments with the experts.

Finally, implement checklists for areas where you’re vulnerable to information avoidance. How much do you draw from your portfolio annually, for instance? Does it exceed the portfolio’s growth rate? What’s your credit card balance? What’s the interest rate on those credit cards? What does it cost monthly to service this debt? Similarly, what’s the balance on your line of credit and the associated interest cost? If interest’s pegged to Prime, what’s Prime? (I’ll help you out here, it’s currently 6.7%.) How much do you spend annually on travel? Dining out? Gym memberships? Gifting? You get the idea.

The best way to counter the ostrich effect is to gather information.

When it comes to your finances, no news is most certainly not good news.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.