Great Lessons from Big Scandals

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.

Comments

[longk:]

your advice doesnt help the class of old ladies very much, given your example of the woman who was following the advice f a profesional. Or, should we say that each and every person in the world should have enough acument to be able to diagnose a stream of returns for excessive goodness? It's hard enough finding a good doctor

2008 Dec 23 12:21 PM

[joe1:]

lesson #1 nobody will take care of your money better than YOU!
lesson # 2 in the last 6 month we have all learned the SEC is useless. I wonder if they are ashamed that they can go after Cuban and Madoff. Then again maybe Cuban wasnt willing to pay to play. I have my doubts if they "failed" to see rather than just pretend it didnt exist. If you watched the CNBC special you realize that they were warned often and did nothing.

2008 Dec 23 01:49 PM

[Marc Gerstein:]

I find this very troublesome in two respects.

First it confuses risk management with fraud detection.

Risk management is pretty much what you described when you discussed the basket of stocks versus a single stocks, and diversification among assets. I think the presentation was oversimplified (there can be huge differences between expected correlation and realized correlation, between expected standard deviation and realized standard deviation, etc.) but it is a reasonable summary of the textbook concepts.

Fraud is a completely different animal. It has nothing to do with the return-volatility-corr... characteristics of what one is investing in. It has to do with one or more persons having criminal intent. One thief can claim to invest your money in all sorts of fancy structured derivatives that will perform steadily and wonderfully but instead pocket your money. Another thief can claim to invest your money in high quality blue chip stocks and U.S. Treasuries and instead pocket your money. Risk management n the parent of the clients is very different. But fraud is fraud either way.

Second, I’m troubled by you recitation of why the an investor should have known better than to put money with Madoff since it’s all after the fact. Did you warn of Madoff on your blog before the fact? Did you send a column to Bloomberg warning of Madoff before the fact? It’s very easy to point fingers after the fact, but it’s a lot harder to do so when it really counts, ahead of time. Yes, a three-person audit firm may warrant discussion for a fund this size, but they were, supposedly, licensed auditors. Maybe, just maybe, that could ring a bell if the fund was complex, but that goes to accuracy of the books, not a full-out Ponzi scheme. And by the way, I don’t think it’s right to bash all small audit firms. I’m sure many are honest and competent. And where is it written that all big firm’s are ethical saints? Have you ever heard of Arthur Anderson? As to the steadiness of the returns, well, that’s what hedge funds in general promised. Many failed to deliver, but to be able to detect trouble in a firm that is claiming to deliver is a task for a sophisticated expert, not the average investor.

The shame here, beside Madoff, is the fact that some such experts alerted the SEC which failed to act. Actually, that is frightening! But I definitely would not use that to suggest that the clients who got burned by Madoff should blame themselves because they were sloppy with risk management.

2008 Dec 23 01:53 PM

[Marc Gerstein:]

Ouch. sorry about the typos; I hit "Publish" too quickly. but hopefully, the points come across.

2008 Dec 23 01:55 PM

[techzone12:]

"You don't know who's swimming naked until the tide goes out".
Madoff was the head of NASDAQ for God sake!. SEC was the watchdog that never barked. Not because they did not know, but because they are corrupt to the core. Many of the people who claim to be victims of Madoff, are actually partners in crime. They most certainly knew that he was doing something elligal. But they figured to enjoy the party while it lasts.

For me, I did my own risk management. First I never demanded high returns from my investments. Secondly, I just followed my own instinct. I bailed out completely from the stock market by the end of last year. I was spooked by the economic envirenment, increased volatility and downward trend that was begining to gain momentum. My prediction is that the market is going to decline further in 2009. There is still a lot of aknowns out there.

2008 Dec 23 02:40 PM

[Vladimir Se...:]

The lesson IS simple: don't confuse risk management with crap like "return-volatility-cor...
This "return-volatility-cor... crap is EXACTLY the problem.
We are attempting to simplify RISK to a few figures in a spreadsheet. That's just wrong and all these scandals prove it.
Yet there is a whole industry of "experts" that get paid for nothing but number manipulation. They have NO domain expertise and they will admit that. Ex: Moody's MBS rating system. What happened when $#it hit the fan? They admitted: they took "numbers" from the sell side, plugged them into their "model" and out came the rating. And if that wasn't good enough, they crunched the numbers some more and got what they wanted. Is this risk management? Yes, for an analyst it is, because this allows him to claim that this is what he is paid to do (i'm just a model developer, not a domain expert) and not go to jail for fraud.
But this risk management only manages HIS risk, not YOURS.

If you want to manage risk you need to UNDERSTAND what you're investing in and having a few figures in a spreadsheet is no substitute.
Pundits predictions, TA, CAPM and any of the other wall street nonsense has nothing to do with risk management.

In order to manage risk, one must develop in-depth understanding in what one owns and for what reasons.

2008 Dec 23 03:03 PM

[sr9web:]

"the future is always unclear, even if the market brochure says different"

Remembering this one point, will save you endless amounts of trouble.

2008 Dec 23 03:41 PM

[sr9web:]

"In order to manage risk, one must develop in-depth understanding in what one owns and for what reasons"

Excellent point!

2008 Dec 23 03:44 PM

[sloane:]

The Marketing Doctor ( blog.marketingdoctor.t... ) actually did a short post on Madoff last week, explaining how his success can be attributed to knowing his Target Market (not that he condones his behavior).

"He knew not to promise sophisticated people unsophisticated (read “extravagant”) returns. In other words, he knew people would walk away if he promised them the sun and moon, but 10 to 15% seemed about right. He was also reportedly very selective —not everyone could become a client— and that kind of exclusivity, if exerted by a credible party (like Madoff seemed to be), can have real power."

Of course, in the end, he had no product to market at all, so ultimately a failure -

Tantillo's full post: blog.marketingdoctor.t...

2008 Dec 23 06:18 PM