Madoff Investers Offer Lessons We Can Learn From

By Martin Brown

madoffChances are you know the story by now. Bernie Madoff (pronounced Made-off) the high-flying financier turned diabolical criminal was sent to jail last week and that is probably where he will remain for the rest of his life.

His crimes? Well many in the eyes of the law, but just one crime that will live on in the rich folklore of American scams, Madoff ran what is commonly known as a Ponzi scheme. That’s where the new money coming into the pot pays generous dividends to the previous investors. Bernie faithfully returned 10 to 12 percent on money “invested” with him. That won him legions of followers, who in turn recruited his next victims.

Bernie’s operation had a very respected pedigree. His reputation as a “financial whiz” was spread through viral marketing inside a cultural circle of wealthy Jewish Americans. “You can trust Bernie,” was the currency of the day. It was advice that was shared over cocktails at the Breakers in Palm Beach, the Four Seasons in Manhattan, the Ritz-Carlton Club in Aspen and other places where the very wealthy gather.

While Bernie preyed upon the wealth of his “family,” this same scheme would have worked on the wealthy upper end of Greek Americans, Italian Americans, Korean Americans and so forth. Why? Because it’s like six degrees of separation–only in this case it’s more like a degree or two. Someone you’ve known for many years, comes to you one day and says, “I never worry about money anymore, and I’ve got it invested with this genius that returns ten percent every year…”

And Bernie did just that for many years–until the markets went south in 2008. Suddenly there was a lot more money due in interest than there was new money coming in to cover the expected payout.

Worse, people who had financial troubles of their own were looking for more than their yearly interest dividend check. They were hoping to withdraw substantial chunks of their invested equity.

By December 2008, Madoff knew the end was near and told as much to his two grown sons, who after consulting with their own attorneys, went to Federal authorities and turned in dear old dad.

The media has been throwing around the term “$50 billion loss” ever since.

It will be many months until there is a more accurate accounting of the damage. In the end that number might stand at more like $20 billion or less. But whatever the final number turns out to be, there is no doubt that many of Madoff’s victims have lost their life savings: a powerful and sobering lesson for a person at any age, and a very bitter reality for many of Madoff’s victims who are 70, 80, and above.

The lessons we can all take away from this are several. Here are my top three:

1. It’s not who you know, but who you invest with. It’s great to have a recommendation from a colleague, friend, or family member. But your hard-earned money should be handled with great care. Betting it all on the “good words” of a dear friend is just not enough.

Madoff’s fund was private, sort of members-only club. People in this club all looked like the shrewdest investors in December of 2007, but like a pack of chumps in December 2008. In general you don’t want to be in a “private club.” You want the bright sunshine of funds that are accessible to the public, and Federally insured by the Securities Investor Protection Corporation, the SIPC.

2. Do your own homework. None of us want to read through every line of a report by the Vanguard Fund or dozens of other investment funds, but at least read the “Cliff Notes.” What is this fund, what is it invested in what is its return on investment history. What made so many real life investment people suspect of the Madoff fund was that it faithfully returned a steady income year in and year out. That’s way outside the norm. Great funds during the same time had years where they made way more than Madoff and years they made way less. An almost flat line of return in and of itself is suspect in the investment world unless you’re talking about a pre-agreed rate of return on a Treasury note, a municipal bond, or a bank’s certificate of deposit.

3. Don’t EVER put all your investments in one place, or one financial instrument. Beyond the fact that all these investors did zip in the way of do diligence, they also put all their eggs in one basket: probably the greatest investment sin of all–and the first lesson every investor learns.

Every wise investment counselor has breached the Tao of Diversity since the time when Abel thought Cain trustworthy. No matter what hype “shrewd” investors may have shared with Madoff’s would be victims, the fault for putting all their money into the same pot belongs to the victims.

One final note: Hats off to Madoff, with an assist from a negligent Securities and Exchange Commission for being asleep at the wheel–even going so far as ignoring the plea of one whistleblower, who repeatedly told the commission that Madoff’s operation was nothing but an elaborate Ponzi scheme. By his own admission, Madoff’s shenanigans ran nearly two decades.

Oh by the way: the original Ponzi scheme, dreamed up by an Italian immigrant named Charles Ponzi in 1919, was exposed within eight months.

When you consider the degree of investment negligence committed by those who invested millions in Madoff’s operation, however, it becomes clear that this was a crime that had hundreds of accomplices, the same people who were also Madoff’s victims!

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