Madoff and some thoughts on Investing
The biggest Ponzi schemer died in prison a couple of days ago. In case you do not know about him or maybe forgot, here is a short recap.
Madoff was a successful professional in the financial markets and ran his own trading business with his sons. On the side , he ran a brokerage business where he supposedly managed other people’s money. This is where he ran a Ponzi scheme which paid early investors with the funds supplied by new investors. Around 2008, when some large investors redeemed their portfolios, Madoff ran out of money and confessed to fraud. When the dust settled, it looked like the total amount the investors had was about 65 billion dollars, but this included the accumulated fictitious profits, so the actual amount invested and swindled was about 19 billion.
Madoff was sentenced to 150 years in prison where he died a few days ago. Madoff’s trustee, Picard and his law firm have recovered a lot of the original investment for the investors. The litigation mess that Madoff’s collapse started will likely go on for the next ten years.
Madoff was way smarter than me and possibly you , otherwise he could not have fooled so many people for so long. Very wealthy , highly educated people fell for his pitch as did sophisticated people working as money managers.
There are many reasons for this. The most prominent one is greed – since Madoff was well-known in the financial markets, lot of people assumed he has some secret strategy that he can use to generate steady returns every year. We teach in finance and economics courses that such strategies do not exist. If someone has a strategy like that, billions of dollars will be available to him for investment, which will lead to a breakdown of the financial system or a nullification of the said strategy.
In the history of the modern financial markets, some people have been able to generate extraordinary returns for a few years , but afterwards they all have closed their funds to new investors. Why? Because they themselves are not sure whether their strategies will continue to be successful .
The greed that I mentioned above was aggravated by second round fraudsters – these people were hedge fund managers who just dumped all their investors’ money to Madoff. Investors lost their money because of Madoff , and many of them sued these fraudsters for negligence, but they mostly weaseled out of these litigations claiming ignorance or simply a bad investment decision. Some of these secondary fraudsters (Ezra Merkin, Walter Noel and others) settled with investors and/ or Picard (the Madoff trustee) , but they still have retained many millions of dollars worth of assets. These people were real lowlife weasels, none of them were found criminally culpable. Apart from the fiscal judgments levied against them , they came out unscathed from this massive fraud – Madoff would not have been as successful if he did not receive massive amounts of hedge fund money from them.
Naivete or sometimes plain stupidity played another part in all this. In spite of the internet being around for many years and a lot of material being available to teach basic financial literacy , I have met people that are shockingly ignorant about the basics of financial markets. Let’s see what their thought processes are.
When you are sick, you go see a doctor who is a skilled medical professional. Give him his fees and He will give you medicine – your health will improve.
When your appliances need to be repaired, you call a skilled repairman, who will, for a fee, fix them.
By the same logic, when your wealth needs to be invested, you will call a professional money manager. For a fee, he will properly invest your money and get you a higher than average return.
The above statement is FALSE . What is true is the following:
When your wealth needs to be invested, you will call a professional money manager. For a fee, he will properly invest your money and get you an average return.
If you find a money manager who is offering you a higher than average return for a fee – do not believe him and do not invest your money with him, It is that simple.
Wait a minute – a doctor earns his fee for his valuable expertise about your body, a repairman gets his fee for his valuable expertise about your appliances, but a financial expert gets his fee for getting you only the average return?
You can get an average return on a bag of money by buying an index fund with it (if you don’t know how, you can learn from the internet in about five minutes!)
Sadly, this is true, which means you do not need a financial advisor to invest in the stock market if you only want the average return (which has been pretty good over the last 80 years – beats buying a term deposit!!). And no honest financial advisor will promise you an above average return! What they might do is to look for short term opportunities for you depending on your risk-tolerance. In other words, they will gamble for you for a fee!! As long as you agree to this, it is perfectly alright to gamble (take risks ) in the financial markets – indeed some people I know have become very wealthy by gambling successfully in the financial markets. Further, some financial advisors will look very hard to get you a tiny little advantage by buying a combination of products. Hypothetically, suppose a bond issued in your city by a educational institution gives a tax break for the residents of the city. If you buy this bond with other products so that you qualify for the tax break, maybe you will get a quarter point extra return above the average on your portfolio for the next three years. If such opportunities exist, along with tax havens in inheritance trusts or foreign countries if you have a lot of money, it is the job for honest financial advisors to find those and charge you a hefty fee if you want to structure your portfolio according to their suggestions.
If you want to take risks, the financial markets are a great place for it. You can always gamble on some obscure stock like “Google” was about twenty years ago and become very rich. You may also never get that winner stock and squander all your money in futile pursuit. The choice is yours, so are the rewards and failures.
Just do not give your money to an old Jewish uncle or any uncle who promises you an above average return by using a secret strategy, Send the money to me, I will double it in a couple of years (just kidding!!).
Did I ever gamble in the stock market? Did I lose big or win big? The details of what I did will remain a secret, but overall I came out a winner , mainly because I got lucky. Because of that I do not invest in the stock market any more. My luck will run out this time.