March 24, 2009
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Bernard Madoff has yet to share with the public the benefit of everything that he learned in his years of running what was likely the world's greatest Ponzi scheme ever. Perhaps he'll reveal all now that he has pleaded guilty, though that is by no means a legal requirement and he seems unlikely to do so. Nonetheless, we are already able to draw a number of lessons from this one disastrous episode in the endless history of financial scandals.
Some lessons are for legislators and regulators, and some are for the supposed experts who advise others on where to invest. Those are not my concern here. I want to consider five lessons in particular, ones that should matter to anyone investing his or her money and financial well-being. None of these lessons is new, and indeed, three at least should be very familiar, but the Madoff affair gives us reason to consider them afresh. I have seen in the press that one lesson is being learned incorrectly, and I hope to remedy that.
I do not suggest that all of those who lost money to Madoff failed to heed these lessons. Some victims were innocent in the deepest sense. These include individuals and charitable organizations who entrusted their money to reputable and well-meaning others who in turn gave the money to Madoff1 without their knowledge, and charities that depended on annual gifts from wealthy donors who lost their own fortunes to Madoff. But the lessons are worth considering all the same.
1. If a promised investment looks too good to be true, it probably isn't good or isn't true.
To apply this ageless lesson requires that one have a standard of what is good enough to be true. That is, one needs a familiarity with the kinds of returns that have been available in the financial markets. With press coverage of the extraordinary returns genuinely earned by some distinguished hedge funds during the last decade and by the endowments of Harvard and Yale (until 2008), the public should be forgiven if it has been confused about the plausibility of various stated returns. All the same, any intelligent person ought to know that you can't consistently, say, double your money over a succession of months or years. A 15% return is very far above the average that any plausible investment strategy could earn over a span of years.
Usually, Ponzi schemes run on the promise of extraordinary returns. Madoff, however, had a fiendishly clever trick for overcoming the usual standard of "too good to be true." Rather than promise most of his investors extraordinary returns, he lured in the cautious ones with a history of a very good but not unreasonable average return combined with extraordinarily low risk.2 In the graph below, from one of the "feeder funds" for Madoff's scam, the steadily rising line represents the purported value of an investment in Madoff's fund.
(If this graph really was constructed from the returns that Madoff was reporting contemporaneously, then he evidently had the good sense and steady nerve to invent returns that were worse than those of the stock market during the dotcom boom.) As Harry Markopolos, the whistleblower who repeatedly reported Madoff to the SEC to no avail, said in his Congressional testimony in February, such smoothly increasing returns, of such magnitude, over so many years, are next to impossible in the real world. Madoff invented a series that combined the returns of stocks and the lack of risk of cash. Regardless of Madoff's claims to have an investment strategy beyond your limited comprehension (as he would have had you think), these numbers were still grossly implausible.
What can an investor do to protect himself from being gulled by such obviously fraudulent data? Unless the investor is familiar with the markets, these data may not appear to be obviously fraudulent. All the same, we know that many of Madoff's victims invested with him because they indeed recognized these returns as extraordinary. That very extraordinariness should have aroused their suspicion, or at least curiosity, and led these investors to consult disinterested or at least trustworthy experts who had an intuitive grasp of the standards for returns and risk. I will return to this when I consider the fifth lesson, concerning trust.
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