There are a lot of traders and politicians out there wondering how exactly it is possible that Bernie Madoff could have operated his ponzi scam for so long and on such a large scale even though whistle blowers like Harry Markopolos were informing the SEC for years that there was wrong-doing. There are some obvious and systemic answers to that question and it is important to understand why from the perspective of a concerned citizen as well as an investor.

[VIDEO] Does Wealth = Intelligence?

Obviously, part of the problem is that the SEC investigators are not competent financial professionals. An agency largely comprised of lawyers could not reasonably be expected to understand the kinds of complex transactions now standard in the financial markets much less be able to tell whether they are honest or not. Learn more about identifying investing scams here.

The second reason could be considered even more alarming. The SEC regulates who may and may not invest in private financial investments like Madoff’s. According to the SEC, only rich people should be considered intelligent enough to either understand complex private investments or to hire someone that is competent to explain it to them. If you are not rich you cannot be expected to understand investing and therefore should be protected from yourself.

Currently you must have a net worth of $1MM and income of $200,000 a year. If you are married, your spouse must also pass an intelligence test by adding $100,000 a year to your income before qualifying to make investment decisions in the private market. Currently about 8% of the U.S. population would be able to qualify. There is a proposal from the SEC to increase those restrictions so that only 1% of the population would qualify.

Unless you believe that wealth does make you smart enough to evaluate investment opportunities, the issue here is that they are using an erroneous measure to determine whether investors are qualified. The measure clearly has no correlation with intelligence or the ability to make wise investing decisions, a stupid person can inherit millions of dollars and become qualified while an intelligent professor of finance may not be.

Operating with biases like this impairs the SEC’s ability to understand what is going on in the world of finance. Not understanding what investors are like leads to bad methodologies for regulation and enforcement. If you make assumptions that a certain portion of the population is more qualified over another based on bank accounts investigation priorities will be skewed and you will operate with blind-spots that allow scammers like Madoff and many others currently operating to flourish.

Image courtesy Andryone.