SANTA FE, N.M. (MarketWatch) -- Unless you've been living on the dark side of the moon, you're aware that New York trading firm owner and sometime investment manager Bernie Madoff by his own admission bilked investors out of an estimated $50 billion.
You're also probably aware that the media is using his record-breaking Ponzi scheme to explain what's wrong with everything from Wall Street to capitalism to Social Security to the Bush Administration -- namely "if it sounds too good to be true, it probably is" (more on that later).
The truth is that the Madoff case, and the circus that's surrounding it, does offer some lessons that can make us smarter about financial advisers and personal finance in general. In my experience, professional investors aren't any smarter than financial consumers, but they do have a much better perspective of how the financial game really works.
So, much as I abhor following the herd, here's my take on Bernie Madoff, why he matters to you, and what you can learn from all this to better protect whatever investment portfolio you have left.
First, let's talk a little bit about Madoff's record-breaking Ponzi scheme. Charles Ponzi was a notorious swindler, who, in the early 1920s, perpetrated one of the most famous financial frauds in history, bilking would-be investors out of millions of dollars (back when $1 million was real money) before he got caught. Today, almost 100 years later, in an ignominious claim to fame, similar cons, such as the one Madoff allegedly ran, are called Ponzi schemes.
Circle game
Brilliant in its simplicity, someone running a Ponzi scheme simply pays his or her investors' a "return" out of the principal he or she takes in from new investors. Since the money isn't really being "invested" in anything at all, the con-person can make the "returns" what ever they want, and pocket the rest.
See related Chuck Jaffe commentary.
Typically, the returns are attractively high, which enables the cheat to attract new investments, some of which he uses to pay the older investors. The flaw in a Ponzi is that eventually, they can't bring in enough money to pay the returns and the con is revealed. This appears to be what happened to Madoff: when the credit crunch drove the market south, his new investment money dried up, some existing "investors" wanted their principal back, and the whole scheme collapsed.
We may never know why Madoff started his fraud. What we do know is that in early December, he admitted to his partners (who are his sons) and then to the FBI, that his "highly successful" investment management business was a "fraud," that he couldn't keep it going any longer, and that would probably cost his investors around $50 billion.
We also know that those investors read like a Who's Who of savvy institutions and private investors around the globe: The Royal Bank of Scotland, The Royal Bank of Canada, UBS Bank, The Thyssen family, Liliane Bettencourt (heiress to the L'Oreal empire), Mort Zuckerman, and Henry Kaufman, to namedrop a few.
The attraction of Madoff's investments is that apparently over the past 20 years or so, he paid out returns of between 1% to 2% each month -- month in and month out. No bad months, no bad quarters, no bad years. Just 10% to 20% a year for nearly a quarter of century, including the recession of 1991 and the dot.com crash. Does that sound too good to be true? Of course it is.
But here's the punch line: His investors knew it, but they didn't care.
Why? Because they assumed he was illegally using inside information from his stock trading business (one of the largest in the world) to the benefit of his investors.
Too good to be true
So, despite red flags dating back at least to Erin Arvedlund's May 7, 2001 Barron's article "Don't Ask, Don't Tell," (a Google search will reveal a list of cautionary pieces on Madoff and whistleblowers longer than your arm), investors kept pouring money into Madoff's investment funds.
Don't believe it? Here's what Henry Blodget on clusterstock.com recently reported: "For years and years I've heard people say that [Bernie's] investment performance was too good to be true... ...and too high given the supposed strategy. One Madoff investor, himself a legend, told me that Madoff's performance 'just doesn't make sense. The numbers can't be straight.' So why did these smart and skeptical investors keep investing? They, like many Madoff investors, assumed Madoff was somehow illegally trading on information from his market-making business."
So, the first lesson from the Madoff mess is that just because something sounds "too good to be true," or actually is too good, doesn't mean you won't be tempted to invest in it anyway. Many sophisticated investors did. But the bigger problem with the too-good-to-be-true advice is that most con men know the "too good" thing, too -- so they tailor their pitches to sound just good enough to be true. (Madoff is the exception because he knew that knowledgeable but greedy investors would assume he was cheating someone, just not them.)
The second takeaway here is that when someone is delivering substantially better returns than everyone else, you'd better know exactly how they're doing it.
Contrary to the impression we often get in the media that Wall Street is a good ol' boys club with everyone scratching each other's financial backs, it's far more like a swimming pool filled with sharks who would eat each other in a second, given the chance.
There are tens of thousands of very smart, highly compensated folks out there managing investment portfolios. Sure, a few of them are smarter than the others, but even then, it's only by a very small margin, which then compounds over time. And chances are, the very smartest guys aren't going to be telling you about it; why would they need to?
When you see someone generating investment returns that are a lot better than everyone else, be afraid, be very afraid. A while back a mutual fund manager told me why his fund didn't invest in the Enron disaster: "We have a guy on staff with 20-years experience in the oil business, but we just couldn't figure out what Enron was doing better than everyone else to make those high returns. So we passed." That's a good mantra for all investors -- amateur or professional.
Bob Clark is editor-at-large for Investment Advisor magazine and covers the financial advisory business from Santa Fe, N.M. 