Infamous con man Bernie Madoff is scheduled to be sentenced any day now. It is a good time to briefly review what happened and ponder how so many successful, and in some cases famous, people fell prey to Madoff’s fraud. In a Ponzi scheme, investors deposit money that is never legitimately invested. Part, if not all, of the money put in by new investors is used to pay off early investors.
Madoff has admitted that he merely deposited client funds in a bank account and used those same funds to pay client redemptions. As reported by Liz Moyer of Forbes, Madoff’s ploy unraveled in late 2008, when the firm was clobbered by $7 billion in redemptions with only an estimated $200 million to $300 million left. Where the rest of the money went – perhaps as much as $50 billion – is still being investigated.
For starters, don’t invest in anything you don’t understand. Madoff claimed to practice a secretive “split strike conversion strategy.” When pressed for details, Madoff brushed aside questions by labeling his strategy “proprietary.”
Another basic investing rule: If it sounds too good to be true, it is. Madoff claimed to provide “consistent 10 percent to 12 percent annual returns in good markets and bad.” (Forbes, Jan. 2009). Two different ways to state essentially this same rule include “high returns mean high risk” and “there’s no free lunch.”
A particularly important point regarding investment fraud is this: Many investors unwittingly let the “fox guard the hen house.” Investing requires three separate functions, each of which should be – but too often are not – independent from each other. First, an impartial investment advisor is needed to assess one’s financial situation and make unbiased recommendations. Second, asset managers must be hired to put money to work in specific investments (usually stocks and bonds). Third, broker-dealers and custodians execute the trades and hold the assets on the client’s behalf. As Forbes puts it, “any time two of these three are housed under one roof, there is potential for trouble.”
Madoff’s firm was investment advisor, asset manager and broker-dealer wrapped up in one unethical knot. That enabled Madoff to document phony security trades and produce false account statements. The solution, of course, is an independent firm like Perspective Financial Services where the advisory, asset management and custodial functions are handled by independent companies whose concern first and foremost is the client’s best interest.