The recent release of the documentary “Madoff: The Monster of Wall Street” has brought the infamous Ponzi scheme back to light. For those too young to remember, Bernie Madoff was an American financier who masterminded one of the largest frauds in history. Worth approximately $65 billion, the fraud spanned the globe and impacted everyone from royalty in Europe, large investment firms, major sports franchises, Hollywood movie stars, and regular retirees just trying to not outlive their funds.
Madoff was held in high esteem on Wall Street. He served as chairman of the NASDAQ stock exchange, advanced the creation of electronic trading platforms, and was involved in other innovations in the financial services industry. He was also heavily entrenched in the Jewish community before his arrest and was involved in many Jewish causes. As such, his scheme disproportionately impacted the Jewish community. From endowments of nonprofits, Holocaust survivors, and successful businessmen, he managed to win the trust, and the money, of Jews from all walks of life.
As I watched the documentary, reliving what I saw unfold firsthand in 2008, I couldn’t help but note several timeless investing lessons that could be learned from the greatest scam in history.
Lesson # 1: If something seems too good to be true in the investment world, it is: Madoff delivered consistent returns and never lost money. There is no such thing as high return with no risk. Risk and return are inextricably linked. If you want to make a lot of money, you need to take a high level of risk. There is no silver bullet that can circumvent this investment axiom. If anyone promises you a high return with no risks, run the other way.
Lesson # 2: Smart, rich, and well-educated people are just as susceptible to fraud as the common man. We often hear about charlatans preying on those who are less sophisticated or down on their luck. Madoff focused on society’s elite to perpetuate the Ponzi scheme. As more money came in, he could continue to keep the entire fraud afloat.
Interestingly, despite their background, business savvy, and educational accomplishments, none of these sophisticated investors noticed anything was amiss. It’s important to recognize that no person or group of people is above being fooled. Be humble about your accomplishments and realize that it may not translate into investment skill or good judgment.
Lesson # 3: Getting access to something special is savvy marketing, but oftentimes leads to poor investment decisions: Madoff’s brilliance was his ability to create the feeling of scarcity. He often told potential investors that he wasn’t taking on new clients. This created a mystique and people desperately tried to find a way in. They’d ask friends, family, or existing clients to do the great “service” of getting them access to Madoff. Investors were thrilled to be part of this select group and didn’t ask many questions on how he was able to generate consistent returns every year.
A theme I bring up often, especially when talking to wealthy investors, is to never let “special access” drive an investment decision. There is no such thing as scarcity in the investment business. The investment landscape has been democratized, with the most sensible investment options now available to everyone. More importantly, no matter how much money you have, the cornerstone of most investors’ portfolios should be plain vanilla stocks, bonds, mutual funds, and ETFs. Anything beyond this should be viewed with a healthy dose of skepticism and undergo a lot of due diligence.
Lesson # 4: Super cheap does not always equal a good deal: Madoff told investors that the only fees he was charging were small commissions for placing trades. Traditionally, money management firms charge a percentage of assets under management. If someone invests $1 million, the money manager will typically charge around 1% of this pool of money. This is standard for the industry. Madoff charged a fraction of that by only generating fees when he placed a trade. (Note: No trades were actually ever being placed.)
This fee structure was particularly attractive to institutional investors known as “feeder funds.” They charged their investors the traditional percentage of assets under management and funneled the funds to Madoff, whose fees seemed negligible. They didn’t ask any questions because Madoff was cheap.
When it comes to the handling of something very important, like your money, cost alone should never drive your decision. Be willing to pay for good advice and service. Furthermore, if someone is willing to do something for free or an amount well below market norms, it’s a red flag.
Lesson # 5: Trying to keep up with the Joneses will only lead to heartache: Groups of friends chatting in shul or the country club was one of the main forces that exacerbated the fraud. Madoff’s reputation in the Jewish community grew exponentially over the years. People wanted to achieve the investment returns that their friends were getting. Obviously, no legitimate investment could replicate what Madoff was doing. Folks ignored all the fraud red flags, blinded by their desire to keep up with their circle of friends. Remember, there is always someone richer, smarter, and more successful than you. Avoid the endless treadmill of comparing yourself to others. It never ends well. It certainly didn’t for Madoff victims searching for superior performance.
Lesson # 6: Cognitive dissonance impacts everybody: Cognitive dissonance is the unpleasant feeling that comes from holding two contradictory beliefs at the same time. Failure to resolve cognitive dissonance can lead to irrational decision-making as a person contradicts their own self in their beliefs or actions.
As mentioned earlier, Madoff was held in high regard by the investing community and his social circles. He sat on impressive boards and received lots of recognition for his accomplishments. This made it difficult for even the most sophisticated professionals to recognize all the red flags with his money management operations. Regulatory bodies, university endowments, and billionaire investors could never in their wildest dreams believe that such a well-respected person could be a total fraud. This led them to ignore all the warning signs.
The best way to try to avoid this common bias is to become unemotional about your investment decisions and implement a system of checks and balances. This may involve appointing an independent body to make investment decisions and various unrelated professionals to review your investment making process. For example, someone may appoint an investment advisor and a CPA out of their social circles to review their investments in an unbiased way.
Lesson # 7: A good salesman can fool even the most sophisticated investors: Madoff didn’t give off the impression of a great salesman, but he was world class in this regard. He didn’t look slick or come off as well polished. However, he created an aura about himself and his firm that made investors of all stripes flock to him.
Unfortunately, there is no perfect method to help someone differentiate between a good salesman and a fraud. The best bet is to trust your gut. Some of the most important decisions people make in life, including who to marry, what community to live in, where to send your kids to school, and what shul to join, can’t be determined by software or calculations. I believe this is also true when it comes to who we can trust. If something doesn’t feel right, then ask more questions and take your time when making a decision.
Sadly, another Madoff will come along and manage to swindle billions from people. You can’t change human nature. However, after reading the aforementioned points, hopefully you won’t be one of the people who are fooled.