An old adage says: "If it seems too good to be true, then it probably is!" About ten years ago, some wealthy investors were given an opportunity to earn an average 12 percent return and never lose money. They invested millions! Unfortunately, this story is true and it didn’t end well.
Investors were attracted to this solid return, which was high, but not absurd when compared with similar investments. However, what really set the manager apart were his consistently positive returns. The manager never lost money in a calendar year. On a monthly basis, the manager only lost money about once every 25 months. If you looked at a graph depicting the manager’s performance over time, it was a diagonal line always moving up and to the right at almost a perfect 45 degree angle.
For those investors that followed the old adage about something seeming too good to be true, their skeptical eye kept them away. For those who couldn’t resist, they invested heavily.
Recently, I heard Harry Markopolis speak about this remarkable manager. Markopolis worked for a competitor and managed money with a comparable investment style, but was losing business to this other guy. Of course investors preferred the other guy; he provided similar returns with no risk. It didn’t take Harry too long to realize the other guy was too good to be true. Markopolos tried to warn regulators and detailed his story in the book, "No One Would Listen: A True Financial Thriller."
Unfortunately, during the financial crisis, everyone realized Bernie Madoff was too good to be true. The investment scam was exposed.
While Markopolis’ recounting of the Madoff story was captivating, his feeling that there are still many Ponzi schemes operating today was terrifying. Markopolis spends his time uncovering Ponzi schemes and other frauds. Because the Securities and Exchange Commission provides rewards for catching fraudsters, this occupation can pay rather lucratively.
The Madoff Ponzi scheme affected investors worldwide, including highly educated investment "experts." Total losses probably exceeded $50 billion. While not on the same scale, many local investors have been hurt by investment professionals committing investment fraud. What can we learn from these unfortunate situations?
How were investors fooled?
They didn’t do their own due diligence. Investors relied on the reputation of Madoff. He was well known on Wall Street and a respected leader in the industry. He was popular and well-liked.
Investors relied on the investment reports they were given and assumed that the appropriate procedures were being followed to verify the accuracy of Madoff’s performance numbers. Unfortunately, Madoff’s audit work was done by a small accounting firm in New York that did not do the required due diligence and signed off without actually verifying anything.
Investors were also eager to invest with Madoff in part because of his brilliant salesmanship. He made investing in his fund seem like an honor where membership had its privileges. As a result, investors gave him large sums of money and didn’t ask questions for fear of getting kicked out of the club.
What do you do?
Take your time. Don’t be afraid of missing out. Rushing an investment decision can be costly and rarely rewarding.
Do your research. Understand who is making the investment decisions and who is policing the decision maker (accounting, auditing).
Dig into the numbers. While fraudsters are good at selling, Markopolis says that they are terrible at math. If you dig into the numbers and see that something doesn’t add up (pun intended), don’t assume you are wrong; assume they are wrong. Which leads to…
Trust your gut. After doing the research, if something doesn’t seem right, steer clear. Even if someone, whose opinion you value, believes in the opportunity, stay away. You may miss out on a good investment once in a while, but hopefully you will avoid the really bad ones.
Totally unrelated but interesting…
Markopolis also mentioned that some of Madoff’s clients belonged to the Russian mob and drug cartels. So when his scheme unraveled, he was quick to plead guilty and get locked up. Moral of the story: If you are going to run a Ponzi scheme, stay away from criminals that are more dangerous than you!
This article was contributed by Bill Wendling, CFA, an Investment Manager at Bedel Financial Consulting, Inc.
Elaine E. Bedel, CFP, is CEO and president of Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. She is a featured guest each Wednesday on the WTHR (NBC, Indianapolis) Channel 13 News at Noon, "Your Money" segment. Elaine’s book, "Advice You Never Asked For… But wished you had," is available on Amazon.com. For more information, visit www.BedelFinancial.com or email Elaine at email@example.com.