At the start of a match, boxers are admonished to “protect yourself at all times.” Investors also must be constantly reminded to heed this advice. Many supposedly sophisticated investors entrusted their money to a firm run by Bernard Madoff, long considered a pillar of Wall Street. In mid-December, the inability of Madoff’s fund to meet cash withdrawal requests revealed that Madoff had, for decades, been running a scam. When confronted, Madoff admitted he’d operated a “giant Ponzi scheme” that had caused his investors $50 billion in losses.
The long list of Madoff’s investors contained myriad names who should have known better. The biggest loser appears to be Fairfield Greenwich Group, a Connecticut hedge fund group that entrusted Madoff with more than $7 billion. Other victims include a variety of hedge funds, wealthy individuals, charitable foundations and foreign banks.
Perhaps if investors took boxing lessons, they’d get serious about protecting themselves from fraudsters and scam artists. In his Saturday radio show, financial commentator Rick Edelman listed several rules every investor must follow to protect himself. Think about committing these rules to memory, and then determine whether your current investments are in the right place.
Beware of financial advisers touting their honesty. Honesty and ethical behavior are prerequisites to a relationship of trust. A financial adviser who feels the need to boast about his or her ethics in print materials or on a website should raise suspicions.
Beware of testimonials. For SEC-registered advisers, advertisements using testimonials are simply illegal. Even references should be regarded with a wary eye. Madoff routinely developed his client relationships through exclusive country clubs to which he belonged. It’s safe to say that the clients who spoke so highly of Madoff’s money-making prowess were living in a world of blissful ignorance, unaware that Madoff was using money obtained from his new dupes to pay “investment returns” to existing clients.
Insist on statements from an independent custodian. In the typical Ponzi scheme, investors receive statements only from the promoter. Those statements invariably paint a rosy—but completely unreliable—picture. If you aren’t receiving regular monthly statements from a recognized, independent broker regulated by the Financial Industry Regulatory Authority (such as Schwab, Fidelity, TD Ameritrade or Pershing), you need to take action immediately. Find another adviser who works through an independent custodian.
Never make out a check to your adviser. If you make the check payable to your adviser or his firm, you’re making it easy for him to operate a scam. Always insist that your funds and securities be held by a recognized, independent custodian. Make checks for deposit only to the independent custodian. A corollary to this rule is: Never give your adviser the authority to disburse funds from your account.
Unrealistic rates of return. Madoff claimed to make a steady 1 percent per month return, year after year. That itself should have been a bright scarlet flag for his investors. Over the past decade, the returns from an essentially riskless investment, short term U.S. Treasuries, have averaged about 4.5 percent. The range of returns has been between about 1.6 percent and 7.4 percent, as determined from the “standard deviation” of plus or minus 2.9 percent. Over the very long term, stocks have provided returns about 4 percent to 6 percent greater annually than riskless Treasuries, but with a much higher variability of returns of plus or minus 15 percent annually.
Madoff’s investors received returns of 1 percent a month (12 percent annually) with no variation. That’s about 8 percent greater than our riskless standard and higher even than risky stocks. As I’ve discussed in previous columns, taking increased investment risk isn’t always appropriately rewarded. But it’s impossible to improve upon returns from a riskless asset without taking on significant risk. Madoff’s returns sounded much too good to be true—and they were. The very stability of the returns Madoff’s investors received discouraged redemptions that might have unmasked the scam sooner. When a promoter or adviser suggests he has a method that generates steady high returns with little or no risk, run (don’t walk) away.
If you don’t understand the strategy, don’t invest. More often than not, schemes to generate unrealistic returns are coupled with claims that the investment firm uses complex strategies, often using jargon average investors don’t really understand. Madoff claimed that a team of three implemented secret algorithms to make the firm’s trades. If you don’t fully understand how the investment firm makes money for you, stay away.
You cannot rely on the SEC. Madoff was able to operate as a broker/dealer for decades with no meaningful oversight by the Securities and Exchange Commission. Columbia Law School professor John Coffee faults the SEC for not paying attention to complaints against Madoff’s firm dating back to at least 1999. Also, according to Coffee, “The fact that this was such a huge fund that employed such a small audit firm and no outside custodian should have triggered red flags at the SEC. Funds of that size typically have a large, internationally recognized auditor.”
If you can’t rely on the government regulators and outside auditors, who can you rely on? Only you can “protect yourself at all times.”
