Round Peg in Square Hole Produces Splinters

After a shocked weekend dealing with what the French will call “The Madoff Affair,” Sunday night finds me thinking about the lessons that have been forgotten. First and foremost, is the lesson that unbelievably good results do not overcome the need for due diligence. The appropriate outlook is the one that cautious investors have relied on since the beginning of handing one’s own money to another: Unbelievably good results ARE unbelievable. Part of the unquenchable belief is imbedded in the alchemy of academics, confusing volatility with risk. In my book MONEY WISE, I try to focus readers’ attention on the real meaning of risk. The real meaning of risk is the large, permanent loss of assets that can change one’s ability to meet life’s goals. In the Madoff case, investors experienced few fluctuations in their consistently high monthly returns. With little or no volatility, the resulting returns produced unbelievably high risk-adjusted returns. We have seen this action occur previously, right before the last Act’s denouement.

Diversification is a basic lesson for all investors, but overlooked in the Madoff affair. No regulated insurance company, and almost no mutual fund could tolerate such little diversification. Many investors (either directly or in funds) concentrated a substantial part of their liquid wealth with these funds. Perhaps more distressing, some used fiduciary responsibilities to direct their charities to do the same. A portion of these same people were moving out of checking accounts this past summer to produce diversification and to get their balances below FDIC insurance levels, as we did. Otherwise intelligent and sophisticated investors were so greedy to capture all of the good returns that they forgot about the discipline of diversification.

The unexpected results of the bankruptcy of Lehman Brothers and the de facto collapse of AIG were not from the size of their debt loads, but from the counter-party risks which froze the assets upon which others had primary claims. The brilliance of the Madoff affair was in not charging a performance fee for superlative investment returns as an adviser, but rather conducting these as brokerage accounts for which they were the exclusive custodian or sub-custodian. Thus all of the risk (and all of the disclosing information) was located in just one place. Thus every investment account had one huge, unrecognized, counter-party risk. The absence of a known auditor sealed the unreliability of the information.

With the exception of this single or small group of perpetrators, all the rest were victims in the Madoff affair - particularly the recipients of the various investing charities. Throughout history we have other examples of “Ponzi Schemes.” Let us hope that in the future people will take more care in turning over their money to unbelievably good results.

P.S.: We feel especially sorry for those investors who entered the Madoff world through an international bank or through another brokerage firm and believed that the stable returns were analogous to fixed income, therefore suggesting that this investment could be done with the benefit of margin. I have heard that in some cases the margin may have been as high as two to three times the original investment. The big lesson here remains that rates of return do not describe the risks of ultimate loss.