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The Madoff Scam: What Can We Learn?

scandalNote: This is a re-publish of an article from early 2009 – but the lessons are still very useful in today’s world.

You’d have to be living under a rock to not know about the scandal of Bernie Madoff’s firm – wherein the supposedly legitimate Madoff bilked some of the most sophisticated investors in the world out of something like $50 billion. The Ponzi scheme has been around forever, for the very fact that it works – much to the chagrin of those caught in its web.

The bright spot for all of us (as long as you weren’t caught in the Madoff scheme) is that the losses we’ve all seen in the the stock market pale in comparison to the losses by Madoff investers. Plus, we have the opportunity to make it back (eventually). These folks lost literally everything invested there, in some cases entire life savings. The vexing part is that many of those folks should have known better. Included in the ranks of people who lost money with Madoff were big banks, Wall Street economists, and, surprisingly, Stephen Greenspan, an emeritus psychology professor who just published a book titled Annals of Gullibility: Why We Get Duped and How to Avoid It.

So How Did This Happen? The way folks were fooled into believing this scheme is that Madoff had a reputation as a forthright and above-board individual. Why, he had once been the chairman of the Nasdaq stock exchange! Most of the large institutions victimized had personal relationships with Madoff and his marketing team, in part owing to the scammer’s earlier position on Wall Street. It is this kind of personal relationship that evokes trust and, in the wrong kind of individual, exploitation of that trust.

But the real enticement came from the consistency of the returns – not earth-shattering in scope, these were relatively modest returns of approximately 1% a month. Considered one month at a time, that’s pretty minimal, but even the average investor should have begun to ask questions when that return continued through up markets and down, with nary a change. Had Madoff offered 10% per month, he wouldn’t have even gotten off the ground, but with this smaller return folks came in by the busload, checkbooks in hand.

And lastly, he came across as an independently-wealthy individual. What motive would someone of his means have for stealing even a dime from someone else? As it turns out, he had every motive in the world, and appearances were quite deceiving.

Lesson #1 from Madoff: If it looks too good to be true, it probably is too good to be true.

Lesson #2 from Madoff: No one can deliver a 1% return per month, every month, in up markets and down. It just doesn’t happen.

What Else Can We Learn? One of the easiest ways to keep something like this from happening is to keep your investing simple. It seems that when complex investment activity is added to an investor’s portfolio, bad things can begin to happen. By complexity I mean getting involved in frequent trading, playing with options, shorting positions, fooling with derivatives, and things along those lines. These are the sorts of investments at the root of today’s financial crisis. While the products in question (mortgage derivatives) are not new to the scene, the history of these products was shaky at best even before September of last year – and we saw what happens when the “perfect storm” of risks comes together. With little forewarning, the entire house of cards comes falling down.

When asked his investment strategy, Madoff touted a complex “split-strike conversion” methodology. That was all the explanation given, and all that the investors (apparently) required. Whatever he was doing seemed to be working, and that was fine with anyone who cared to wonder. It’s unknown if Madoff ever invested a single dollar, or if he just churned the new money back out the door to the earlier investors, in the classic Ponzi style.

It is a common belief that there is a group of folks (the “smart money”) who can beat the market all the time. It’s my opinion that no such group or individual exists. Just look around you: if there was any “smart money” around, you’d have seen those companies or mutual funds faring well during the meltdown last quarter. Unfortunately there is no crystal ball – and given the firehose of information available to us these days, very little can escape notice.

This is not to say that no one ever beats the stock market averages. On the contrary, there are some mutual fund managers every year who beat the average, and some do it consistently (although not many). As I have mentioned on these pages in the past, less than 3% of all fund choices in a particular category will beat the index for an extended period. With odds like that, why not stick with the simple, tried and true index strategy?

Lesson #3 from Madoff: Keep it simple. Understand your investments, and why they make money.

In addition, Madoff acted not only as advisor, but also as brokerage for his client-victims. In other words, when making an investment, clients would just hand over the money to Madoff, rather than a third-party brokerage. With everything under one roof, Madoff was free to do whatever he wanted (and he did) with no checks and balances.

Lesson #4 from Madoff: Know where your money is going, and check on it regularly. Utilize a third-party between you and your advisor so that you can independently verify that your money is invested as you desire.

It’s a terrible thing that the folks who trusted Madoff have nothing to show for their lifetime of investing. Knowing what we know today, he probably still would have suckered in quite a few folks. But if we pay close attention to the lessons that we can learn from this scam, hopefully you and I will avoid being pulled in to the next scheme like this that comes along.

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