Madoff Black Box vs. Gut Feel

Chidem Kurdas

Bernard Madoff told Securities and Exchange Commission examiners an evolving tale as to how he made money. He started with a black box, which may sound like another reason to suspect computerized models. One examiner wrote: “no discretion on the part of Madoff—everything is determined by the black box.”

Then Madoff changed his tune. Yes the computer model signaled when to enter and exit the market, but he “was adamant he also uses his ‘gut feel’ to make these decisions.”

The lesson from this little story: it is better to be presented with a black box than to be told the guy’s gut is making the money. 

The particular SEC examiners who came closest to catching Madoff were primarily concerned that he might be front running his brokerage customers, using information from their orders to trade for his investment clients. But there was also the question of whether Madoff should be registered as an investment adviser, which became the main issue for another group of examiners.

Madoff trotted out the notion of his black box by way of explaining that he was just executing trades for hedge funds, not managing money, and it was all automatic, there was no looking at brokerage orders. That led the examiners to ask questions about his black box.

With hindsight one can see why he changed the focus of his explanation. Of course he had no “box”. So he switched to the gut feel theme. They can’t ask to see a guy’s feelings, can they?

The SEC examiner who came nearest to calling Bernie’s bluff was not convinced. “I thought his gut feel was, you know, strange, suspicious. You know, I kept trying to press him. I thought there was something else.”

That something else did not show up until years later when Madoff confessed. The moral is that a systematic approach or model, something you can investigate, should be reassuring as the first step to due diligence. Yet many people are suspicious of black boxes. It makes more sense to suspect gut feelings.

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