How to avoid the next Madoff scam

Updated: September 1, 2015

What can we learn from the Madoff fraud? Let’s start by listing what we know about it:

  • The investor group seemed like a private club – only the invited could invest. Many investors were friends with each other and with Madoff or introducing advisors.
  • Madoff was unwilling to describe his strategy. Inquiring too deeply into the strategy or its results may have caused the invitation to invest to be withdrawn.
  • Madoff or his company issued customer statements.
  • Madoff reported positive (and very stable) returns in all market environments.
  • Many investors in Madoff’s scheme had most or all of their assets with Madoff.
  • If Madoff had really been using his claimed strategy for the amount of assets he claimed to have, his trading would have swamped actual market volumes.

Each of these facts (except perhaps the last) was visible to many or all of Madoff’s investors. They provide powerful clues to how you can avoid being a victim of the next investment scam.

Fundamentally, the lesson is very simple: when it comes to investing, Ronald Reagan’s “Trust, but verify” motto turns out to work extremely well. However, it may not be immediately obvious how to apply it when a specific investment opportunity arises.

The following table addresses each of the “facts” and provides specific recommendations about how to protect yourself as consider any investment.

Madoff scam “fact” How to protect yourself (trust, but verify)
The investor group seemed like a private club – only the invited could invest. Many of the investors were friends with each other and with Madoff or introducing advisors. Insist on objective assessments before you invest your money. Your money is too important for you to invest it solely on the advice of friends.
Your friends may be excellent judges of service quality; they are extremely unlikely to assess advisor investment skill accurately. Even professionals and academics have great difficulty in divining investment skill. An objective and respected third party such as Morningstar or Financial Engines is your best source of information if the advisor claims extraordinary skill or results.
Finally, ask yourself and your friends why the advisor is running a club rather than a business, and why the advisor is offering to include you (why are you so important to the advisor?).
Madoff was unwilling to describe his strategy. Inquiring too deeply into the strategy or its results may have caused the invitation to invest to be withdrawn.

You (and your independent objective advisor such as your accountant, your lawyer, or your financial planner) should understand the investment strategy, and should be able to explain it in words a ten year old child can understand. If you can’t understand the strategy, you can’t evaluate it.

Importantly, some investment managers claim to have “proprietary” investment strategies and processes that other managers would copy if they became known. Such managers should still be willing to summarize both strategy and process. For example, if the strategy involves buying “undervalued” stocks, you can understand the concept without knowing the specific algorithm they use.

Marketers know that buyers like to be “in on a secret.” Mystery may make perfume or clothing more enjoyable and prestigious, but it is the road to ruin in investing.

Madoff issued customer statements.

You should receive statements from an independent third party custodian. This will allow you to verify several essential facts:

  • The value of the securities in your account as reported by the third party is equal to the value of your securities as reported by your advisor. This will protect you from Ponzi schemes: if your securities are in your account, they can’t be used to pay off other investors. [This raises another important point – if you see only an undifferentiated fund on your statement rather than individual securities, you need to see periodic audited financial statements for the fund. The auditor should be a firm whose name you recognize.]
  • The returns as measured by the changes in your account value are equal to those reported by your advisor.

The transactions in your account are consistent with your investment advisor’s strategy as you understand it. Thus, for example, if your advisor is buying “undervalued” stocks, the transactions in your account should involve stock purchases and sales, not options or borrowing on margin.

Madoff reported positive (and very stable) returns in all market environments.

If it sounds too good to be true, it probably is (too good to be true).

Investing in stocks is risky. If someone offers or promises “guaranteed” returns as good or better than stock returns, with less risk, walk away (actually, run away).

Many investors in Madoff’s scheme had most or all of their assets with Madoff.

Diversify.

  1. Hold the world market portfolio. This is as diversified as you can get.
  2. If you insist on taking non-market risk, diversify it
    1. Divide your non-market investments among multiple advisors (portfolio managers who select individual securities such as stocks, bonds, or derivatives such as options and futures).
    2. If you work with an advisor who selects mutual funds, satisfy yourself that the funds cover a broad range of investment categories – large and small companies, US and international, multiple industries – concentrated portfolios are riskier than diversified ones.
    3. If your employer offers a 401(k), insist that the holdings be diversified and transparent, or don’t invest in it. Non-diversified holdings pose extra risk, and without transparency, you have no idea what you own.
If Madoff had really been employing the strategy he claimed to use for the amount of assets he claimed to have, his trading would have swamped actual market volumes.

Perform due diligence; check out the advisor:

  • Assess the advisor’s reputation with the governing regulatory or certifying organization – check with the SEC for investment advisors, FINRA for brokers and CFP Board for financial planners. If the advisor has no regulatory affiliation, why not?
  • Who is the advisor’s custodian? Does the custodian have requirements that the advisor must meet?
  • Meet with the advisor. Ask for his or her qualifications. If you were hiring a doctor, you’d want to know where she went to medical school, and what her specialty is. An advisor should be happy to tell you about their academic background, how they learned about investing, and about any certifications they hold such as the CFP® or CFA.
  • If you are unfamiliar with the advisor’s strategy, seek an objective third party evaluation. Objective means that you, not the advisor, should pay the evaluator.