Gather Little by Little

It was a good news story wasn’t it? Much of the world did not even know what a Ponzi scheme was, let alone that it could provide a way for Bernard Madoff to perform the single most important fraud ever. On the surface, it is interesting and certainly a sensational way to sell newspapers. But beneath the surface lies a much bigger issue. Fact is that almost any investor could be fooled by such a scheme. Many of the investors that lost everything did not even know they had investments with Bernard Madoff. It has become very important for all investors to take measures to avoid falling victim in similar situations. Losing your lifetime savings or every penny owned by a charitable foundation is tragic enough when you hear about it on TV. Just imagine when you are centre stage of such a drama.

Here are 5 steps I would personally recommend to reduce the possible exposure/loss but also to avoid investments in fraudulent funds.

#1-Don’t believe everything friends and family tell you: Many of the investors who got involved did not even look into the investments purchased because they had been told about them by very close friends and family members. This is a tragic mistake. In all cases, the recommendations were sincere but the problem is that if one of your close friends or family is not careful enough, this means that you will make the same mistake. Even if the fund is recommended by trusted advisors, you should still ask questions; find out what the investment is, etc.

#2-Know what you own: Many Madoff investors did not even know they owned holdings related to his funds. How is that possible? Usually, they had given discretionary control of their investments including their entire retirement to an advisor. Even if that is the case, you should still be able to ask what you actually own, down to a fairly decent amount of details. Many investors held investments which included funds of funds. So basically, you own a unit of “company X” which owns shares of Bernard Madoff’s fund. First of all, you should always ask to know what is owned by such funds and chances are that any investor would have noticed that his fund only owned one holding might have asked a few more questions. In most cases, you will be able to know what you actually own, even if it is as of a prior date (end of quarter is usually a date when funds will release their holdings). If you are not able to know what you own, get out of the investment.

#3-Fund & Returns history: You have surely heard that “What’s too good to be true usually is”. In the investment world, that is also very true. Sure, some funds are able to put up good performance numbers over a long period of time. But no fund is able to return over 10% year after year without something being very fishy. There are thousands of corporations that try to find good strategies and if such a fund were to exist, it would have been copied. In the case of the Madoff Ponzi scheme, this was without any doubt the biggest alarm to any investor using due diligence. It seemed too good to be true to have a fund performing so well for so long.

#4-Fund Allocation: Funny how the world works. In many cases, investors that have good returns in a fund will invest more and more cash in the fund every year, hoping that it keeps on going. Actually, you should be doing the opposite in most cases. If you have decided to invest 10% of your holdings in a given fund and that fund doubles, you should be selling some of your units in order to remain at 10%. On a one year period, it does not have a huge impact. But over a few decades, this can result in having a very sizeable portion of your savings (often close to 100%) invested in one single fund. Even without the risk of fraud, this strategy is not a very smart one.

#5-Diversify managers: There are so many options when investing, why would you ever decide to give 100% of your money to one person. I agree that when you are starting off and have 20-30K to invest, it is probably not worth having a few different managers. But as you accumulate savings, you should be diversifying not only your holdings but also your assets. I’m sure that Morgan Stanley has excellent funds to invest in. But surely you can find other good ones in order to diversify your savings rather than be dependent on one single company. Think of those who had assets with Lehman Brothers. A year after the company’s unexpected bankruptcy filing, many individuals and corporations are still fighting to get their assets back.

Can you ever be 100% safe from getting caught in a Ponzi scheme? Probably not. But I really do think that following these 5 steps will go a long way towards making your financial future a little bit safer!

author: Mike