Lessons From Madoff: You Would Have Missed Buffett Too

The tide went out in 2008 and Bernard Madoff was found to be swimming without a bathing suit. His investment firm collapsed this month, being “basically, a giant Ponzi scheme.” This video on YouTube is quite amusing – it shows Madoff in better times, explaining his investment approach to a room full of people.

The lesson here is that you can never be too skeptical as an investor, especially when it comes to choosing and using an advisor. If something seems to be good to be true, it usually is. Everything must be challenged. And I mean everything.

Most of all don’t put all your eggs with one adviser! Spread them around. Or join the do-it-yourself brigade, which doesn’t take much work if you follow the Couch Potato Portfolio or One-Minute Portfolio approaches.

I personally prefer to do it myself. I likely would have even turned Warren Buffett down when he was soliciting investors for his investment partnerships in the late 1950s and 1960s. Here are some snippets on the legend’s modus operandi from Roger Lowenstein’s Buffett: The Making of an American Capitalist:

“He warned [investors in his investment partnerships] that he would disclose nothing about where their money was invested. He would give them a yearly summary of results, nothing more. Also, he would be ‘open for business’ only one day a year. On December 31, his investors could add or withdraw capital.”

“One time a partner barged into the reception area … intent on finding out where his money was invested. Buffett … told his secretary he was busy. She returned in a moment and said the man insisted on seeing him. He disappeared for a minute and then told his secretary, ‘Price that guy out [of the partnership] ‘…he added, ‘They know my rules. I’ll report to them once a year.”

Buffett’s partnerships were reporting out-of-this-world returns. During his first ten years, from 1957 to 1967, there were four years with market losses ranging from 6.3% to 15.1% but Buffett’s partnership posted gains in all four, ranging from 10.4% to 22.8%. His total return over the period was 1,156%, nearly ten times the gain in the Dow Jones average of 122.9%.

I’m not saying Buffett established his reputation by running a secret Ponzi scheme. He obviously is a diligent and brilliant stock picker and could have pulled it off. But if I had been at one of Buffett’s pitches for investors, I would not likely have joined. To me, the lack of disclosure, restricted liquidity, one-man operation, and a track record “too good to be true” would have been warning signs of the potential for a Ponzi scheme.

Of course, I would have missed out on becoming wealthy alongside Buffett – successful Ponzi scheme or not. It seems you are damned if you do and damned if you don’t when it comes to picking advisors. You can never tell beforehand. I’m happy to do it myself.

Comments

[Brad Ferris:]

It's amazing really that investors don't demand better transparency for the money they entrust to those who manage their money. Investors need to demand stronger oversight and conflicts of interest need to be weeded out of the regulators so the proper job can actually be done. This would never fly in the pharmaceutical industry or with many of the largest regulated utility companies.

2008 Dec 25 10:21 PM

[Alex Filonov:]

That's risk/reward problem. Low risk, low reward, high risk, high reward, no way around it.

2008 Dec 25 10:39 PM

[Steve in TN:]

I would never place my money with any advisor that did not have a custodian where I couldn't see how I was invested. That is a custodian or independent brokerage house where the advisor couldn't withdraw the funds. He could only trade my account.
There should be a federal law mandating this approach. If this were followed there would be no Madoff victims or any other Ponzi scheme losers.

2008 Dec 25 11:52 PM

[HTuttle:]

Buffet is long overdue for a crash himself. The blind adoration he has right now should be a clue.

2008 Dec 26 12:42 AM

[Ricard:]

Good article on personal finance. I was wondering when you'd get to index funds, and then I clicked on your links.

Agreed that Buffett's sales pitch seems to try to convince the buyer not to buy. I suppose the difference is that Buffett hasn't made a partnership exclusionary (BRKA is a public company, and has been for a while), while trying to convince future investors not to invest. All the while, he has been making very public statements demonstrating his style and acumen.

@Alex Filonov:

"That's risk/reward problem. Low risk, low reward, high risk, high reward, no way around it. "

Read "Security Analysis". The verdict is: the more a stock drops, the lower the risk AND the higher the reward IF you apply sound business principles to the stocks you research. Example - KEP around 2003-2004 was selling for 1/3 book, P/E below 6 (earnings were growing too), ample cash, monopolistic rights. It promptly tripled. Low risk, high reward. I found out Buffett went big into Korea for similar reasons several years after I had made large profits on this one, and most importantly, IT WORKED.

@HTuttle:

Buffett actually has come out and told the public for years now not to expect outsized returns in this market, and especially for BRKA, given its bloated size and the market's over-leveraging with derivatives. Not too many fund managers go that far on a limb to un-promote their own fund.

2008 Dec 26 01:13 AM

[Guero:]

"Couch-potato" portfolio? How about "Gold bullion in a coffee can buried in the backyard" portfolio? That's where it's at right now.

2008 Dec 26 10:06 AM

[De Graaf:]

When you listen closely to the two hour interview with Bernard L. Madoff and Josh Stampfli, you come to a viewpoint of the puppetmeister. The master Madoff himself controlling the strings of the market maker puppets.

He even explains how the regulations (Chinese walls) between broker divisions in one company are so strict, that the only way to make money is taking risk. Well we know now he did that without any scrutiny.
He knew all the market algorithms were lined up with eachother and therefore the market was being 'made of' these trading mechanisms.

With these automated IT market making systems, the market had to go up as long as liquidity remained available. And the Bush government made that possible, by supplying of low lending rates and deregulations. That same government made the bubble unsustainable, and the bubble came off.

The innovation in automation IT business is always ahead of the regulatory curve, so like Madoff basically said; Foul play will surely happen. The answer thats missing is advanced oversight.
The free market has been overly innovated, in a way that safety, in the form of regulation and overisight by the SEC, is way behind the curve.
Excesses granted and being uncovered in times of economic downturn like we see today. The Madoff scheme. Ponzi is out, Madoff is the new name of the game in the 21st century.

The need for immediate returns, like Madoff says; 'everybody wants' is spurring the need for faster markets. Automation was a wonder system that Madoff's LLC company grabbed with both arms to keep ahead of the regulatory curve. His brand name was also the driver in market acceptance over time being chairman of Nasdaq etc.

Its show how people truly are and greed in finance is always a factor. The needs for regulation and especially oversight in-line with market innovation is essential for the future of finance.

I surely hope the new financial system being formed in the coming years will make sure, innovation stays on top of the curve with regulation just behind the curve, instead of following at the trough of the curve where it is right now.

That is my Christmas wish. Happy holidays to everyone.

2008 Dec 26 11:11 AM

[Brad Castro:]

Good article and good point about doing it yourself. Relying on others--even smart, honest, and trustworthy people--doesn't always work out. Just look at Bill Miller and Garrett Thornburg. I greatly admire both, but I'm glad I had no investments with either.

2008 Dec 26 01:39 PM

[Fabien Hug:]

For Buffet it's too late to share the bounty, I think. Now what about the next Buffet. Nobody knows. The basic rule to diversify is always valid.
The problem is you may not have enough capital to diversify properly, particularly if you want to go into hedge funds. The temptation could be to choose one fund of fund...don't.

2008 Dec 26 03:11 PM

[long_on_oil:]

Investors buy stock once a year just to be able to attend the Berkshire annual meeting. To try to infer Buffet is in the same league as Madoff is utterly ridiculous. I have followed and owned Berkshire for years and Warren Buffet is about as open as he can be and still make money for the stock holders. Sure, he keeps secrets to prevent the leaches from jumping on when he is starting to accumulate a position but that is only natural for a great manager.
If you read any of his essays you will learn about the man. He admits his mistakes along with his successes. Very few managers do that.
All you Buffet bashers are just stabbing in the dark, shame on you.

2008 Dec 26 11:18 PM

[Old Rick:]

Wakeup: if you had read any of the decent (and even some of the not-so-decent) Buffet biographical works, you would know that in the early years, Buffet invested in fairly risk free arbitrages (making 20% or so annualized) and in Ben Graham style "cigar butt" stocks he picked out of various stat manuals. One of those cigar butts was a small New England textile company that turned out to be a terrible investment for the partnership. I sure don't know where the complaint that he is a "bullying, narcissistic" person comes from. If you know something about him that those of us who have been following Buffet for lo these nearly 40 years don't maybe you should enlighten us. That said, it would have been very difficult to invest in the partnership under his rules.

I think the give away in the Madoff case would have been the near consistent 10% or so returns that went back to "some" investors (in spite of serious market volatility) where Buffet's returns varied with the market, but on the high side. I heard on Fox Business today that a firm hired to do due diligence on Madoff recommended his client not invest as Madoff's returns were "near mathematically impossible". Don't remember the DD firm name.

2008 Dec 27 12:34 AM

[mauikaualua:]

You raise a lot of interesting points here though I'm not sure you are quite aware how interesting they are.

2008 Dec 27 10:45 PM

[JanSimposn:]

Nicely done - Investing is like loaning money - you give your money freely, you understand the law states 9/10 possession theory - so if you get it back - well consider yourself lucky - if you don't consider yourself lucky to have had the experience and learn from it. Someone must have needed your money more than you and hopefully they enjoyed it. Time to move on.

2008 Dec 28 09:08 AM

[nport:]

I say it's your money..do it for yourself..an IQ of 100 will do nicely. Buffett has said.."This is not a game where IQ matters..Just be normal or average, have patience, be determined." Read..read..read..lear... Buffett's Math and his alphabet..CDM Circle of competence, Durable Competitive Advantage, Managers who think like owners, Margin of Safety. Be greedy right about now, and be fearful when they say this time it's different. I say don't trust anyone under 30..come to think about it, don't trust anyone over 30. WEB also said, "We like to hire people with 2 qualities, Intelligence and integrity. If the latter is lacking, the former will kill you."

2008 Dec 30 10:02 PM