How could Madoff happen?

Lots of people are convinced that if they had been offered the chance to invest in Bernie Madoff’s hedge fund back when it was a thing, they would have turned down the fraudster. His offer of 12 percent annual returns was simply too good to be true, they say. Between his infamous secrecy and lack of advertising, they would have seen through the scam.

Permit me a moment of skepticism. The idea that investors could be this savvy seems fantastical now in part because of Madoff’s spectacular success—and downfall.

Madoff, who died Wednesday at age 82, spent the final 11 years of his life in prison for orchestrating one of the largest investment frauds of all time. Victims included individuals he met through Florida and New York country clubs, Hollywood stars, Holocaust survivors, university endowments and hedge funds. It wasn’t just the naive who gave money to Madoff.

How could this happen? It helps to recall that from the early 1980s, when the great bull market of the 20th century began, to the inklings of the financial crisis in 2007, the idea that a smart money manager could help workaday investors churn out steady gains was common currency. Financial media promoted the concept.

The contours of Madoff’s scheme, which experts have variously dated to the 1970s, 1980s and 1990s, were a classic Ponzi scam. Madoff paid “gains” to older investors with money coming in from newer ones. His ploy lasted until the financial crisis in 2008, when many people wanted out and few wanted in.

The fall was swift and brutal: Victim losses were estimated at $20 billion in original investments and $65 billion in recorded paper wealth. After he went to jail, Madoff dismissed the people who fell for his scam as “greedy,” but his rationalization was the opposite of the truth.

In contrast to most Ponzi schemes, people weren’t looking to Madoff to help them get rich quick. Individuals and businesses flocked to Madoff not because they were hungry for better-than-average stock market gains but because his touted annual gains—steady but not eye-popping—offered security they couldn’t find elsewhere.

I’ve long been convinced that there is a link between the end of Madoff’s scheme and the overwhelming popularity of index-fund investing in the aftermath of the financial crisis. It’s not simply that, as The Wall Street Journal theorized, people realized pricey money managers hadn’t seen what was coming. Nor was it merely that the regulators’ cursory investigations into Madoff’s fund left many dubious of all sorts of investments (and the officials tasked with overseeing them).

Instead, Madoff demonstrated the lie that almost any savvy individual investor could produce steady gains in a way that nothing else could. By destroying the retirements and dreams of so many, he inadvertently performed a much-needed service.