10 Simple Investment Rules for the Very Wealthy

I didn’t think that the uber-rich needed my advice until the last few days. After all, they are the uber-rich and I am one of the “little people." I figured they knew more than me and it was from their special knowledge that they got their uber-status. But after the last few days I believe that the uber-crowd is just like the rest of us: clueless, scared and in trouble.

As if the last 18 months of banking and brokerage meltdown weren’t enough to prove that the world is broken, the Petters and Madoff collapses are beyond rational comprehension. Both frauds were predictable, stupid and massive. The Tom Petters fraud was based upon a ridiculous “investment” strategy that barely had the trappings of sanity. And Bernie Madoff’s investment magic was based upon being a nice guy who belonged to cool clubs. Of course, no one had a clue what he did with their money but lots of people liked to play golf with him.

If the uber-rich follow my 10 simple investment rules they should be able to avoid the next Petters and Madoff.

Rule #1 – Don’t Invest In Stuff You Don’t Understand

Over the years, uber-investors have tried to explain to me how a “split strike conversion strategy” works. But since I was a little person, I was never smart enough to understand what they were talking about. Even using historical data to reverse engineer Madoff’s strategy, I couldn’t figure it out. As it turns out, no one else understood either.

Many structured bonds sold since 2001 fall into the category of “too hard to figure out”. For example, I can’t figure out most collateralized debt obligations (”CDOs”). And, there are uber-rich who right now are putting their money into funds that were formed to invest in cheap CDOs but who have no idea of what a CDO is or why it is cheap. These investors are investing in stuff they don’t understand and will sooner or later get burned.

Rule #2 – Try To Use Common Sense

Petters claimed that his business made tons of money buying and selling more than $15 billion per year of name brand TVs, refrigerators and other consumer goods because top-line manufacturers wanted to keep it “secret” from retailers that they had inventory to sell. As an example, Petters claimed that every year Sony (SNE) wanted him to sell staggering numbers of TVs to retailers at big markups because Sony needed to keep it a secret that they were in the TV business. Apparently investors forgot that that it isn’t a secret that Sony is in the business of selling TVs to retailers. And Petters wasn’t keeping anything secret. He quickly told all his important secrets to anybody with cash that he could steal. His business plan made no common sense. The uber-rich need to remember that common sense is important when deciding where to invest their money. If it doesn’t make common sense, don’t invest.

Rule #3 – Risk and Return Are Correlated – The Higher The Return The Higher The Risk

Uber-rich don’t borrow money at really high interest rates and neither do little people; that is, unless little people are a bad credit risk or desperate. In 2005 and 2006, the uber-rich and their uber-investment banks thought that little people and their businesses would pay really high interest rates even though they had lots of collateral and good credit. For some reason it never occurred to the uber-crowd that there were thousands of old-style commercial banks and thrifts who were quietly lending to good borrowers at low interest rates and that high rates of interest were being paid by high-risk borrowers who probably weren’t going to pay back their debts. The simple idea that high returns are correlated with high risk was forgotten. The uber-rich need to realize that when lenders claim to have low risk portfolios but lend at really high interest rates they aren’t telling the truth. If someone says that they can get really high yields without taking risk, don’t invest.

Rule #4 – Leverage Increases Risk, A Lot

The uber-rich need to learn that they shouldn’t buy into investments or companies with bad balance sheets. These are crummy investment opportunities. Too much leverage makes good operating businesses bad investments. Before doing anything else, investors must analyze balance sheets to determine if the business has a good financial foundation. If the balance sheet stinks, don’t bother looking at the income statement and don’t invest.

Rule #5 – Cheap Isn’t The Same As Valuable

Many uber-investors think a strategy of buying well known stocks because they have gone down in price is the same as being a value investor. Unfortunately, often stocks are cheap because the underlying company is terrible and doesn’t have a future. As an example, early investors in bank and brokerage stocks thought that because some of the stocks had gone down in price they were a value. But those investors didn’t do fundamental balance sheet, income statement or business analysis. They didn’t know that when it comes to stocks, cheap isn’t the same as valuable. Don’t buy stocks because they are cheap unless fundamental financial analysis also says that they are valuable.

Rule #6 – If Management Acts Like Thugs, Don’t Invest, Even If They Are Really Well Dressed Ivy League-Educated Thugs

The uber-rich are often fooled when management teams are well dressed, well educated and use big words. What the uber-crowd doesn’t understand is a good education doesn’t teach good morals. Some of the smartest people are some of the rottenest. Thugs never let people really know what they are doing, because what they are doing is wrong. Really good thugs pick the pocket of the uber-rich by hiding behind complicated words and sentences that prove their educational pedigree but mean nothing when torn apart. If management doesn’t tell investors what they are doing so that a little person can understand, don’t invest.

Rule #7 – Uber-Country Clubs Aren’t A Great Place To Make Investment Decisions

The uber-rich believe that their cash has magical powers to grow when they make investment decisions in the rarefied air of an exclusive country club. However, scamsters love exclusive country clubs because they can quickly and efficiently figure out where to find large concentrations of uber-victims. Also, country club deals provide scamsters the added benefit of gathering together investors who believe it is socially unacceptable to go “postal” if they lose their money. The Madoff scandal will test the social bonds that underlie the postal theory. Until the uber-rich stop making investments because of the magic of their country club, they are destined to continue to blow their wealth.

Rule #8 – Ronald Reagan Was Right; Trust But Verify

Trust but verify. It works for financial nukes just like real nukes. The one common thread connecting all of the major financial scams of the last 20 years is the inability to verify what was going on. Investors shouldn’t invest if they can’t verify what they are being told.

Rule #9 – Don’t Invest In Stuff You Don’t Have Time To Figure Out; Buy Treasury Bonds Instead

A whole cottage industry grew up around the idea that uber-investors were too busy to tend to their investments. After all, uber-rich were too busy to raise their kids, clean their houses or mow their lawns. It only stands to reason that they were too busy to worry about their investments.

So “funds of funds” sprang up so that the uber-rich could hire someone else to do the pesky work of deciding which exclusive investments they should put their money into. The idea of hiring someone to hire someone to invest in companies that hire people to do actual work is dumb. After fees are paid to the multiple layers of advisors, there is little left for investors without unreasonable risk. And, it is no coincidence that most of the money lost in both the Petters and Madoff frauds was funneled into these scams through funds of funds. Don’t invest in any fund of funds. Treasuries are better.

Rule #10 – When In Doubt Re-Read The First Nine Rules And Then Don’t Invest

If you aren’t sure, don’t invest. There will always be another opportunity.

Comments

[herbert hoover:]

I believe Madoff has made a stellar case for confiscatory inheritance taxes.

2008 Dec 15 11:57 AM

[Chris B:]

This decade has been really good for my self esteem.

First, I discovered that I am smarter than the president and his entire cabinet. I'm smart enough to be leader of the free world - too smart perhaps!

Then, I discovered that I was right about $750,000 being too much for middle class people to afford to pay for a modest California or New England bungalow.

Now, I discover that I am smarter than the billionaires and "masters of the universe" who ended up investing in pyramid schemes (nonetheless, the schemesters still have their millions, so maybe they're smartest of all).

2008 Dec 15 12:26 PM

[Bill M:]

If everyone followed Rule 1 and Rule 2, we wouldn't be on this mess we are in.

2008 Dec 15 12:32 PM

[Jackson Cash:]

Here's what I will tell the uber-rich whom are all (yep ALL) disconnected from reality, hiding behind their fortune:

"If you are going to be dumb, you better be tough."

2008 Dec 15 01:11 PM

[Archman Inv...:]

I thought number 5 was a good one.
I see that all the time : "It's cheap so it must be a buy".
People certainly learn that the hard way.

2008 Dec 15 01:41 PM

[Pent up demand:]

#9 is a good one. Don't invest in funds of funds. A couple FOF that are failing were collecting fees to run the "place money with Madoff strategy." So they were collecting 2/20 for placing money with another manager with zero insight into how he made his returns. They don't have much room to criticize Madoff as a crook.

2008 Dec 15 03:30 PM

[Hedged In:]

Excellent article.

2008 Dec 15 04:37 PM

[A fool and ...:]

It is easy to take pot shots at the wealthy when they get scammed. Hindsight is a great view when it is someone else who has their hind handed to them. I know numerous people who were scammed in the Petters fiasco who lost way more money then they could afford to lose. All this because they wanted less risk and consistent returns. These weren't individuals looking to take risk... just the opposite. Easy to call them stupid now, but where was your good advise over the 13 years the con was being perpetrated???

2008 Dec 15 09:47 PM

[sr9web:]

Good post.

2008 Dec 16 01:10 AM

[Mark Sunshine:]

Dear Fool and His Money,

The author here,

I had the opportunity many times to invest in Madoff. I didn't because I followed my own rules.

In the case of Petters, the Petters group directly and indirectly attempted to get First Capital to lend to them. I made sure that First Capital (the company I am President of) refused to lend because I thought it was a fraud. Also, I got a number of my friends out of the Petters fund. I was outspoken and considered a little crazy on Petters.

So, as the say, I not only talked the talk but walked the walk.

Thanks for reading.

2008 Dec 16 08:19 AM

[boet:]

Some love him, some don't. But Sunshine did indeed call the Petters fraud a year ago -- I heard him trying to talk a fund of fund manager out of investing in Petters. They thought he was way too animated, and continued to invest. Also, I know he called the housing bust back in 2005 and 2006 and dodged the bubble. Love him or not, but the guy's consistently made good calls.


On Dec 15 09:47 PM A fool and his money... wrote:

> It is easy to take pot shots at the wealthy when they get scammed.
> Hindsight is a great view when it is someone else who has their hind
> handed to them. I know numerous people who were scammed in the Petters
> fiasco who lost way more money then they could afford to lose. All
> this because they wanted less risk and consistent returns. These
> weren't individuals looking to take risk... just the opposite. Easy
> to call them stupid now, but where was your good advise over the
> 13 years the con was being perpetrated???

2008 Dec 16 12:16 PM

[fatcat:]

Agree with you Boet,I have actually learned some things from Mr.Sunshine...unlike most of the crap on the interweb...

2008 Dec 16 12:30 PM

[Market Folly:]

haha good post thanks for the read. amazing the trust people place in others.

i'd offer up our post on hedge fund manager interviews for those (wealthy or not) wanting to truly understand alternative investments & their managers better: www.marketfolly.com/20...

2008 Dec 16 01:02 PM

[Alicia_Finance:]

Great points!

Goes to show that no one is immune from financial mishaps......

Alicia
Wall Street Survivor
www.wallstreetsurvivor...

2008 Dec 16 04:09 PM

[User 321166:]

I have known Mark Sunshine in a professional capacity for close to twenty years. He can be accused of being strenuous with his opinions and a bit of a crusader, but he is not a Monday morning quarterback. During our time working together, he has had a clairvoyant ability to see fraud and other malfeasance around the corner when it was inconvenient or difficult for others to see it. Using his background as a lawyer, accountant, investment banker and business builder, he has warned me off of several potential problem investments in my current company, where people were deceiving themselves about the investment practicality of several financially structured games of musical chairs. Over the years I have seen him accurately call the deception of traders marking to model (or worse) values of "Z" tranches in the early 90's (Wall Street never learns -- this was a pre-cursor of the mark to market catastrophe with derivatives the banks experience today), I saw him give a vein-popping disposition in Washington over lunch to a congressman in 2006, calling out the impending residential real estate bubble collapse, and the involvement of Fanny and Freddy in this mess. I have heard form third persons about Mark's spirited arguments with a potential client warning them off of Petters a year or so ago as a giant fraud, chastening the client to lighten their position in Petters (so I am told independently). In summary, Mark is not a 20-20 hindsight kind of guy, taking pot shots like so many talking heads on TV. He has been up there with his opinions early, often representing "inconvenient truths" in the wilderness, that the establishment would rather not listen to. American capitalism and our position in the world financial markets has been inestimably damaged by the deceptions that have gone unchecked or undiscovered during the past several years, due to a combined failure of business leaders, political leaders, the press and the regulators. If it were up to me, I'd appoint Mark head of the SEC tomorrow.


On Dec 15 09:47 PM A fool and his money... wrote:

> It is easy to take pot shots at the wealthy when they get scammed.
> Hindsight is a great view when it is someone else who has their hind
> handed to them. I know numerous people who were scammed in the Petters
> fiasco who lost way more money then they could afford to lose. All
> this because they wanted less risk and consistent returns. These
> weren't individuals looking to take risk... just the opposite. Easy
> to call them stupid now, but where was your good advise over the
> 13 years the con was being perpetrated???

2008 Dec 17 07:48 AM

[Nancy Kazdan:]

Great article on many fronts. in my opinion, the fact that people don't ask the questions by going deeper to actually understand what is meant and how investment strategies impact them and their money seems so simple and a blinding glimpse of the obvious. Unfortunately, this is not the case. The fact of the matter is that the complexity appears mysterious and asking for clarity to the point of understanding is a time consuming process for both investor and investment professional/seller. If the committment to really communicating complexity to the point of understanding happens on both sides and the responsibility can be shared and the surprises a la Madoff might have a tougher time. I have worked communicating complex financial information to individual professionals through to people with functional literacy in manufacturing plants. Believe me the latter was harder work but the reward greater. They sat and listened then interacted by asking questions.It took my team of 25, including actuarial, 7 months of planning through to execution but we had a fantastic outcome for the new pension fund opportunity.
It can be done and your top 10 is fantastic but at the end of the day will people really be willing to ask and understand?

2008 Dec 26 07:57 PM