Top 5: Investing lessons from Madoff scandal

A few weeks back, ABC did a two-part miniseries on the Bernie Madoff scandal.  It speaks to how busy two little cubs can keep a fox that it took me that long to watch the show on DVR.  Ahhhh, parenthood.

Here’s a quick primer for those not familiar with Madoff:  He ran a hedge fund which turned out to be a $50 billion pyramid scheme.  He’d take people’s money, say he was investing it, give them statements showing awesome returns, but all the while he just kept the money in his bank account.  When the Great Recession hit and everyone wanted to take their money out of the market, his investors went to get their money and Madoff finally confessed that he perpetrated probably the largest financial fraud ever, in any country in any era.

Overall, I enjoyed the miniseries, but I’m really into personal finance so that shouldn’t be too surprising.  Obviously Madoff is a cautionary tale of fraud and cheating, and how you as an investor should avoid those things.  No kidding, right?  You might as well say not to drive on the day you’re going to have an accident.

But investing fraud still happens, all the time, every day.  What are the lessons you can take from the Madoff case that can help you avoid being ripped off.

 

Top 5 lessons from Madoff

5. Remember that you’re the boss: One of the major reasons that the Madoff fraud was able to go on for so long is that no one ever took their money out.  It’s not that the investors didn’t want to get the money every once in a while, but when they went to make a withdrawal, they were told that if they took their money out they wouldn’t be able to reinvest it at a later time.

That implied threat is a little bullsh*t.  It’s like a kid saying if you disagree with him, he’ll never be your friend again.  It’s your money and the investment advisor is working for you, not the other way around.  Any time you want to do something with your money and you’re told “no” that’s a massive warning sign.  Now maybe you want to do something that doesn’t make sense (like cash out your 401k), and there it’s appropriate for your advisor to help you make a good decision.  But it is your decision and once you’ve made it, your advisor should support that decision 100%.  If it is anything less, you should run the other way.

 

4. Keep it simple, stupid: Madoff claimed that he was using a very complex investing strategy that involved options and other really complex derivatives.   It had a lot to do with investing in equities and then doing short covering with by selling calls or buying puts.  Confused yet?  That’s a bit of the point.

Had Madoff actually been doing what he said he was doing, it was an incredibly complex strategy that very few regular investors would understand.  Hopefully one of the things we learn from this column is that investing is simple.  Doing things like investing in index mutual funds to minimize cost and maximize diversification aren’t that complex.  Neither is taking advantage of the tax benefits of 401k’s or 529s or IRAs.

Actually, my experience, and something you have heard me say countless times on this blog, is that when you go away from simplicity and start to get into complex investments that’s when everything goes to hell.  The fact that Madoff used that complexity to facilitate his fraud is just another reason to keep things simple.

 

3. If it’s too good to be true, it probably is:  Somewhat related to #4 is the age old wisdom that if it seems too good to be true, it probably is.  What made Madoff’s investments so appealing is that he consistently had returns in the 10-12% range year after year, in good years and bad years.  Of course we know that in investing there is a fundamental tradeoff between risk and reward.  The fact that Madoff was producing high returns with very little risk (variability in those returns) should have been a major red flag to investors.  You never want to look a gift horse in the mouth, but you also don’t want to keep your head in the sand.

And actually many of Madoff’s investors knew something was fishy.  They just thought he was “front running.”  That’s an illegal practice where he would know the orders that others were placing and then invest right in front of those.  Think of it this way: if you know there is going to be a major order to buy Coca-Cola stock, you could decide to buy Coca-Cola just before the big order hits.  When that big order does hit, it will likely increase the stock price, and you benefit from that rise.  It’s totally illegal, but it’s also a great way to do really well in the stock market.

This is a bit of a sad commentary.  Madoff’s investors were fine when they thought he was cheating and they were benefitting from it.  But if you play with fire you get burned.  They were right that Madoff was cheating but it turned out they were the victims.  Somewhat ironic.

Anyway, back to the moral.  If you know something is fishy, you need to figure it out.  Hopefully this blog has helped set expectations for you on the stock market—stocks average about 6-8% over long periods of time but there is a ton of volatility from year to year.  If someone is claiming to defy gravity, you really need to take a long, hard look at what’s going on and figure it out.  Which leads us to . . .

 

2. Understand what your investment advisor is doing: When people would ask Madoff how he got those consistent, high returns we mentioned in #3 he said he really couldn’t explain it because it was too complex #4.  So we’re seeing a few problems here.

However, people were fat, dumb, and happy (plus add greedy to that list), so they left well enough alone.  But that’s a major no-no.  Even if you have someone helping your with your investments, you should still know what’s going on with your money.  For your advisor to respond “it’s too complex; you wouldn’t understand it,” is just unacceptable.

I get that for some investment advisors there is a proprietary nature to their work and how they pick their investments.  Telling you gives away the secret sauce, and it’s understandable that they wouldn’t want to do that.  Of course, I totally disagree with that because I believe in efficient markets, but I can accept that other people see things differently.  That makes this a really sticky issue.  You really should understand what is going on with your investments.  If your person is unwilling or unable to explain that, then you should probably find someone else.

 

1. Do it yourself: This is a little bit of a snarkey comment, but there’s a lot of truth to it. Madoff stole from people for his own benefit.  You know the only person in the world who can’t steal from you for their own benefit?  YOU.

Of course, that’s not to say you shouldn’t trust others, but trust is a big word, and especially in investing there are a lot of unscrupulous people who are waiting to steal your money.  If you distilled this blog down to a central there, it would be that with investing you can do it yourself.  This isn’t rocket science, although some people try to make it more complex than it needs to be #4.  This can be simple stuff that over the long term is virtually guaranteed to make you money.

 

There you have it.  My Top 5 lessons from the Madoff scandal.  Investing is a critically important part of preparing for your future.  The path is lined with crooks and cheats, so beware.  But let’s not end on that pessimistic note.  You can do an amazing job investing for yourself and that can protect you from the frauds.  That’s better.