Lessons From the Madoff Scandal

If you had the good fortune never to have invested in what may end up being the biggest Ponzi scheme in history, count your blessings. An alleged fraud like this could have happened to any of us, as it did to some of the world’s most sophisticated investors. There are lessons here, though not necessarily the ones that have been touted by much of the media.

Now that some of the dust is settling around the Bernard Madoff scandal -- he allegedly admitted to bilking his investors out of at least $50 billion -- there has been a growing tendency in some quarters to blame the victims, at least in part. According to these theories, they should have recognized that annual returns of around 10% in both good times and bad were too good to be true. They should have been suspicious of Madoff’s vague explanations of how he arrived at those results. And to the extent he described his strategy, which involved the simultaneous purchase of stock and sale of option contracts, they should have noticed that there wasn’t sufficient volume in those options trades to account for the reported gains.

The lesson from such criticisms, I suppose, is that we should all turn ourselves into forensic accountants. I find that preposterous, not to mention distasteful, given that some of these people have lost their life savings. After all, consistent returns in good and bad markets are the selling point for nearly every hedge fund. There are plenty that have reported much larger annual returns without raising eyebrows. Indeed, Madoff's returns were good, but not so spectacular as to raise undue suspicion. As for his vague explanations, they were no vaguer than those of many other hedge fund managers and even mutual fund managers. No one wants to give away his or her trade secrets. And as for the volume of trading in options contracts, what investor has the time for that kind of detective work, even assuming it might have revealed some irregularities?

True, some potential investors examined Madoff’s operation and declined to invest. The same could be said for nearly every other hedge fund. In 2006, one potential investor actually branded it a Ponzi scheme and took his suspicions to the Securities and Exchange Commission. The SEC investigated and, amazingly, gave Madoff a clean bill of health after he corrected some minor issues. How that could have happened remains one of the big unanswered questions of this affair, and the SEC owes the public a detailed explanation. Nonetheless, Madoff’s victims can surely be forgiven for relying on what is supposed to be a watchdog agency.

Still, there were some red flags, and lessons that we should all take to heart.

• Madoff’s books were audited by a virtually unknown accounting firm and apparently just by one man. So the simple but vital lesson here is to never invest in anything — hedge fund, partnership, mutual fund — whose books aren’t audited by a recognized accounting firm with a strong reputation and numerous clients, preferably one of the Big Four. Check your investments for the name of the firm that provides the audit. If you don’t recognize it, research it on the Internet. This simple step would have saved investors from the alleged Madoff fraud.

• Diversify. This is obvious, but bears repeating given the many stories of people and institutions who tied up almost all their assets with Madoff. While it's especially hard to reduce an asset that seems to be doing so well, it's the essence of rebalancing and diversification. After all, it doesn’t take a fraud to expose the folly of concentrating too many assets in one place. A sharp market correction can have the same damaging effect.

• Don’t believe anyone who tells you that you can earn higher returns while assuming a lower risk. This is the mantra of every con man I’ve ever known. If you’re realizing high returns, you’re also accepting increased risk.

• Don't rely on middlemen. Many Madoff investors were steered into their investments by highly-compensated advisors. With the proliferation of hedge funds and other alternative investment opportunities, such middlemen have grown increasingly popular. Many people don’t want to have to think about their investments, but you can’t abdicate all responsibility.

• At the same time, don’t lose your faith in human nature. I spoke last week to a money manager with an unblemished reputation for integrity who had just spent four hours defending herself to a client who said she couldn’t trust anyone in the wake of the Madoff scandal. Madoff is an especially shocking example given that he allegedly defrauded his own sons, close friends, and charitable institutions he purported to support. But he is an aberration. The vast majority of money managers are honest, hard-working professionals with their clients’ best interests at heart. The financial system operates on trust backed up by regulation. Both failed in Madoff’s case, but that doesn’t mean everyone is a crook.