Great Lessons from Big Scandals

by: James Picerno

The Madoff investment scandal may be the biggest Ponzi scheme in history, in which case the swindle offers oversized as well as familiar lessons in what not to do with the care and tending of money.

Reading the ongoing news reports of how this crime was executed summons a range of emotions: frustration, sadness, shock and anger, to name a few. All the more so because so much of the investment pain was easily avoided. At least in theory.

The Madoff sting is only novel for its size, duration and complexity. Nonetheless, the fraud raises yet another opportunity to review the argument that risk management is always and forever the priority for investors. Common sense, perhaps, but it's also a rule that's constantly disregarded by far too many investors who somehow think they're immune to loss, legitimate or otherwise. In some cases such thinking may be due to ignorance, although greed and fear are almost always part of the equation as well, along with a healthy dose of hubris. Whatever the reason, ignoring risk management is like drinking and driving: You may be able to avoid hitting a wall tonight, but eventually you're going to crash if you don't change your habits.

If there's any good that comes out of the Madoff hoax, it's the reminder that investors should be risk managers first and performance chasers last, if at all. The point has been made countless times before in the investment realm, including our discussions over the years, such as here and here. But apparently the world needs another reminder, and probably always will.

Focusing on risk management is like breathing: It's a helpful tool for survival. Risk, after all, can be controlled to a far greater degree than return. A simple example, but hardly the only one: Predicting the returns for individual stocks is difficult, if not impossible, particularly if you're looking at many different equities. In that case, the risk of owning any one security is extraordinarily high. But with the decision to own a basket of stocks, the equity risk is effectively contained. What's more, we have a high degree of confidence that it will be contained, i.e., risk is lower compared to owning a handful of stocks. And if we add bonds and other asset classes with low and negative correlations to stocks to the mix, we can further enhance our control over the nature and extent of risk. We may give up some return in the bargain, relative to taking more risk with fewer securities. But a good risk manager/investor can maximize risk-adjusted returns and do quite nicely over time.

Such talk is par for the course on these digital pages, although it's hardly standard procedure in the wider world of investing, much to the detriment of the folks who fall prey to promises of big profits that are seemingly immune to the hazards that befall others. The instances of investors going off the deep end, and paying a heavy price, are many. In September, we discussed a pair of news reports that highlighted the folly of letting greed and overconfidence dictate one's choice of investment strategy.

The Madoff con only lends additional support to the realization that risk management doesn’t come naturally to investors. Today's Wall Street Journal provides another especially confounding example related to the Madoff affair. A woman, we're told, lost virtually her entire investment portfolio, valued at $2 million. To quote from the story, in 2001, acting on the advice of her broker, she poured something close to her life savings into a hedge fund linked to Madoff. "By October 2008, her account statement said her investment was valued at $3.8 million," according to the Journal. "On Dec. 11, Mr. Madoff was arrested and confessed to a $50 billion Ponzi scheme."

Even if you thought Madoff was the real deal, the first rule of risk management is never — never -- put everything in a single investment, be it an asset class, your brother-in-law's dry cleaning business or an actively managed strategy, much less one that smelled funny. Regardless of how alluring the expected return, the future is always unclear, even if the market brochure says different. Depending on the investment in question, we can have varying degrees of confidence that the principal is safe; less so with regard to the prospective return, if any. But in the end, there's no guarantee and so you'd better make sure you know what you're getting into. Even then, betting the farm on any one thing, or any one manager, is nothing more than rank speculation. Confusing that with investing is like comparing glass with diamonds.

Common sense, right? Apparently not. Why, for instance, didn't the steady returns that Madoff claimed to earn set off warning bells for his clients? Didn't they realize that such return histories are the stuff of dreams rather than of a legitimate money management shop? If you're taking investment risk and your return series looks like a money market fund, it's time to wonder. Or, how about the tiny auditing firm that Madoff used to check his books? Didn't investors realize that a 3-person auditing operation was far too small to legitimately conduct prudent oversight on a firm claiming to manage billions of dollars? Then again, did investors even look at the auditing firm? One might reason that a cursory check is at least required before handing over millions of dollars to a firm with privately run investment strategies that, at the very least, looked like a black box.

Yes, the Securities and Exchange Commission failed to see the Madoff fraud, even though it was tipped off several times that something was wrong.

The SEC's failure is a scandal in and of itself. That said, let's be clear: You're asking for trouble if you're expecting the SEC to protect your portfolio. Yes, securities regulation is beneficial and necessary. But that's assuming the regulators take the time to investigate fraud when it's staring them in the face. Long story short: Don't assume.

As we've all learned (again) in these past few weeks, there's a limit to how much you can depend on others when it comes to risk management. It's your money: Keep it that way.