Inflation assumptions are a critical part of the retirement planning process.
When you consider the thousands of people who fell prey to Bernard Madoff’s $65 billion fraud you have to wonder whether your assets could fall prey to a similar disaster.
While the losses from Madoff’s Ponzi scheme are tragic for his victims the real tragedy is that had those investors followed some basic rules of prudent investing, they never would have invested with Madoff in the first place. Madoff’s scheme succeeded because of its lack of transparency, its foundation of trust based on social connections, and the belief that market beating returns come with no risk.
What follows are basic steps to ensure that client investments are in the hands of people you trust, including ensuring ethical broker/advisor behavior, following a specific investment plan and securing an independent custodian and auditor.
Warning Signs
Madoff convinced his marks that they were investing in a hedge fund. Hedge funds are typically open to a select group of investors, are run by an investment manager who increases rather than decreases risk and are not closely regulated by the government. The exclusive nature of hedge fund membership creates an aura that attracts investors who feel they deserve exclusive treatment. In addition to their sex appeal, hedge funds lure investors with the ever elusive hope of market beating returns with low risk. Nearly every element of the Madoff affair mirrors the earmarks of classic Ponzi scams:
- Trust in the promoter due to some social affiliation
- Lack of complete transparency of the investment strategy
- Returns on investment that seemed too good to be true
- Investments that the investors did not understand
- The entire scam unraveling rapidly
Investors should have been warned by the very consistent returns touted by Madoff that something was amiss. Results that are too steady over the long term are a warning sign of possible fraud. While the stock market has rewarded investors for taking risks, those rewards do not show up every year. Some years bring losses – sometimes significant ones.
Prudent Investment Principles
When evaluating an investment advisor, you follow common-sense principles. Avoid managers who are unknown, don’t come with good referrals or haven’t been in business for very long. However, this is only a start because, this alone, would not have saved you from Madoff. He had friends at the highest levels who gave glowing referrals, he was the former chairman of the NASDAQ and had been in business since 1960.
At the core of every investment engagement should be a written “investment policy statement.” This document details an agreed upon strategy between client and advisor that the advisor will follow and be held accountable for. The IPS is a document that clients should clearly understand, and the advisor should not deviate from without client consent. A trustworthy advisor requires an IPS because they want a clear roadmap to follow. If an advisor isn’t willing to abide by an IPS, get another advisor.
There is only one thing an advisor can control – Risk. This is accomplished by designing portfolios that have the greatest opportunity to meet client goals with no more risk than the client has the ability, willingness or need to take. This is spelled out clearly in the IPS.
Academic research indicates that the prudent strategy is to capture the returns that the markets provide. This understanding means giving up on the idea of “beating the market” – but it also means avoiding the risk of underperforming the market. Madoff’s victims fell for the too-good-to-be-true trap – beating the market with no risk.
Accountants and Independent Custodians
Find out who audits your custodian of your assets. Independent auditors are crucial because they verify the existence of the assets in the accounts managed by the advisor. Madoff had audited financial statements, but they were prepared by a three person firm. A no-name, three person shop auditing a $65 billion hedge fund.
Finally, make certain there is an independent third party custodian. When handing money over to a financial advisor, the check should be made out to an independent custodian institution, typically a brokerage firm. If an advisor managing investments and the funds are held at, say, Charles Schwab or Fidelity, it’s next to impossible for that advisor to run a Ponzi scheme.
Madoff was able to perpetrate his fraud because he operated in the shadows. By contrast, publicly traded mutual funds operate with a high level of transparency. Some of the advantages of investing in publicly traded investments are:
- Publicly held mutual funds are a highly regulated industry governed by the Securities and Exchange Commission. Hedge funds are essentially unregulated.
- Mutual funds must have audited financial statements.
- Mutual funds do not perform the fund’s accounting themselves.
The saddest part of the Madoff fraud is that if investors had followed the basic rules of prudent investing, the tragedy could have been avoided.
