These are tough times for trust. Successful marketplaces — indeed, all social systems — require a level of ethical behavior among their participants. The recent arrest of Bernard L. Madoff, accused of bilking thousands of investors in a $50 billion Ponzi scheme, is only the latest incident to diminish trust on Wall Street. Wharton operations and information management professor Maurice E. Schweitzer and G. Richard Shell, professor of legal studies and business ethics, have conducted extensive research on the role of trust in markets. In an interview with Knowledge at Wharton, they explain why even the most sophisticated investors put their faith in Madoff and how his actions have damaged markets in general.

Knowledge at Wharton: Why is it that even sophisticated investors are being snookered in Ponzi schemes, still?

Maurice Schweitzer: The Madoff scandal is a story about several powerful influence principles working in concert. These are textbook principles. And in this case, you have four that are key. One is scarcity, where investors were told, “The fund is closed. But maybe I can get you in.” It was exclusive, and there were some clients that got fired [because they asked too many questions]. The second key principle is authority. Madoff was somebody who in 1990 was the chair of NASDAQ. He pioneered electronic trading. He was a board member. He had this air of authority. And we know from the Milgram experiments and other studies that authority figures exert a huge amount of influence over us. Third, social proof. Everyone’s doing it. From the Abu Dhabi Investment Authority to Line Capital of Singapore, to Stephen Spielberg and the owner of the New York Mets. You look around and everybody else is investing here. It seems like a reasonable thing to do. And fourth, the liking principle. We’re influenced by people that we like. And here, social networks, meetings in country clubs, the charity events — this is what brought people in. So you have in concert these four classic influence principles working together. And on the other hand, you have motivated reasoning. You have these investors who want to believe. They want to believe that they can earn the 10%, 11% interest, like clockwork. So they’re willing to suspend their disbelief. And I think we failed to realize how powerful all of these factors are, when they work together.

Knowledge at Wharton: If the allegations against Madoff are true, this scheme lived longer than most Ponzi schemes. How was he able to sustain this?

G. Richard Shell: There was a failure of regulation. That seems to be getting explored in Congress now. And this particular scheme was remarkable in that the con artist conned the regulators as well as their investors. Maurice’s point about the authority that this fellow had is partly responsible for that — because [Madoff is] one of them. When you’ve been the head of the NASDAQ, you’re inside the tent as far as the regulatory group is concerned. It’s very difficult when there are no outward visible signs of fraud, to pick this up. And then it built on itself, so that as years passed, it became more and more credible. I think that in hindsight, it looks easy to spot, because it was a secret formula. He didn’t reveal it to anybody. There were quite a number of people who decided not to play, because they couldn’t see behind the veil of where the money was coming from. They look pretty smart now. But when you’re doing this prospectively, and you have this opportunity, they look like the suckers. They look like the people who are being overly prudent. And the smart money is getting involved. So I think the length of this one has something to do with the fact that he was able to con the regulatory system at the same time he was conning the investors. That’s a double whammy that’s really hard to pull off over a period of time and over many different markets.

Knowledge at Wharton: Was he not also getting some help from the performance of the market at the time, when he was doing these operations?

Shell: Well, yes, at different periods in that time. Because the markets went up, the markets went down. He survived the dot-com bubble. The things that seem so obvious now — he was reporting to his customers more options being traded for a given customer than were traded during the entire day that he was purporting to be trading them. It seems so clear in hindsight. But people weren’t sharing their reports with each other. And as Maurice said, again, this sort of desire to believe can be very, very strong. You don’t want to take in the evidence that contradicts your belief. It requires you to undo so many assumptions about what your life is about, and who you’re hanging out with, that it’s just cognitively and emotionally too high a price to pay. So you just get the report, and put it in your desk and forget about it.

Knowledge at Wharton: Are there ways, though, to overcome that instinct for investors? Are there specific steps that people should be taking to protect themselves from this kind of disaster?

Schweitzer: I think there are some classic ideas here. One is the basic principle of diversification. Some of the investors clearly forgot this point when they put all their eggs in one basket. Clearly we should be diversifying our portfolios. The second, as Richard mentioned, is oversight, where you have examples of investment managers like the manager of GMAC, who charged fees to others to dump money with Madoff, with no oversight. And the third is to check for flags. Sometimes when returns are too good to be true, they’re too good to be true. Richard mentioned the lack of transparency. I completely agree with that point. And the lack of independent auditing, which is so important. It’s easy to get swept up with this, swept up with the crowd and everything else. But there are these basic principles we should be following.

Shell: No scam or Ponzi scheme ever existed without greed. And even Benjamin Franklin, the founder of our great university, when he was returning to America to take up his residence here in Philadelphia and do all the great things that he did — he wrote a note to himself on the boat coming back, four principles to live by for life. And one of them was, “Do not get taken in by any get-rich-quick schemes.” This was 1760. I think that we can say that this impulse to do better than the market, and to do it in a way that will take care of your financial problem — whether it’s all at once, which is the usual Ponzi scheme, you get 100 percent return — or over a longer period of time. But nevertheless, in a way that doesn’t mimic the way real markets work, which is what Madoff [offered]. But that impulse is something to be very, very significantly wary of in yourself. [People] really get used to the fact that there’s risk, and get used to the fact that work is probably what’s going to create wealth more often than financial investments.

Knowledge at Wharton: Still, underlying all of this is the sense of trust. The most transparent investment still requires the investor to have a level of trust with whoever the investor is doing business. Are the markets going to be harmed because of this?

Shell: I think so.

Schweitzer: Absolutely. There’s a contingent process, where you have other investors who are now going to be much less trusting of legitimate, honest hedge fund managers and investment managers. There’s going to be a lack of liquidity, so the markets are going to be harmed by this.

Shell: The real tragedy in this one is that there are a whole set of intermediaries who were legitimate financial advisors, as far as we know, but who took money that was invested with them, with the assumption that it was going be diversified. And they put it all into the Madoff operation. And so you have two levels of distrust there that have been created. One is with this hedge fund type model that Madoff was running. And I think pretty much everybody’s a little skeptical of hedge funds in general anyway, because of the way the markets have turned out. But the more difficult thing to figure out how we’re going to get over it. Tremont Capital [and other] people who, for all intents and purposes, are legitimate managers of money. People in good faith gave them that money, and then without being told, had all their money put into this Ponzi scheme. And so, how do you know which financial advisor you’re going to be able to trust going forward? There are even brands involved that are pretty respectable, under theaverage person’s frame of reference. So I think it’s a blow to the average investor’s confidence that when they give money to a financial advisor, they’re going to get it back.

Knowledge at Wharton: And as you said before, the ways to make money often involve work. And so you want to trust but verify when you go into … any kind of an investment. So, you have to actually pay attention to the progress of your investment and see real documentation, which requires more than just filing away the reports.

Shell: Well, I think we can take a lesson from a few of the people who didn’t invest in Madoff. Ben Stein wrote a column in The New York Times a couple weeks ago. He was approached to invest with Madoff. I think he … engaged in a good process. He’s a pretty smart guy. This was 20 years ago that he had this opportunity. But he took the opportunity, presented it to two sophisticated advisors, and asked them to give their opinions on whether he should make this investment. They both looked at it. Since they had no interest of their own — they weren’t financial advisors, they were just people giving an opinion — they said, “This looks like it’s too good to be true. I can’t figure out how it could possibly work the way it’s supposed to work, so I’d stay away from it.” And so he did. I think that’s a pretty good model. Get financial advice, but not from interested parties. Don’t rely exclusively on the advisor. But look for second opinions, the same way you would for a medical problem. And I think the chances of your getting taken in by one of these might go down, if you’re looking for more diversification not just in the assets, but in the advice.

Schweitzer: I think one of the long-term harms from this process is clearly this need for oversight and second opinions. It’s a cost on the system. It’s drag, and it’s clearly necessary. Trust is like lubrication. It makes transactions easier, faster, cheaper. It fuels the economy, so we can trade. And we’ve lost some of that trust. So now the costs are going to go up. There’s more friction, as we have to do more due diligence. I think that’s necessary. And clearly, it was necessary before this. So perhaps the silver lining is that we’re going to get back to these basic principles of oversight and diversification.

Knowledge at Wharton: Even before this, with the sub-prime problems, a lot of trust was lost.

Shell: Yes. We have burned a lot of trust in the last three months … not just in America, but in the whole western capitalistic model. And it’s no surprise that at the end of the day, the irony here is that a Republican administration in the United States has just basically been the catalyst for the Europeanization of the American financial markets. And it’s not going to change. We’re now in a European situation, for the financial markets. There are no more investment banks. That is a different model, altogether. It’s not as freewheeling. And I think, you know, we’ve been burned. And it’s going to be a while before people are able to get themselves back into the mood to be taking risks. But, you know, to Maurice’s point. There’s no way that any social system can work without trust. So we’re still going to have to trust each other, somehow. And the interesting question is going to be, what institutions will rise that will allow us to do that? I think the rating agencies are going to change. The way stocks and investments are evaluated will change. The transparency levels will change. But the average person who’s got money to invest, I think is going to have to be a little more vigilant, looking after their own interests.

Knowledge at Wharton: Thank you both very much for joining us today.