5 lessons to learn from Bernie Madoff
Bernie Madoff's incredible $50-billion Ponzi scheme didn't target just the rich and famous. He bilked many middle-class investors out of their life savings, too.
When the 71-year-old swindler was sentenced to 150 years in prison, his victims berated him as a "monster." A "beast." A "nightmare." The federal judge vilified his "extraordinarily evil" fraud.
So what can we learn from this tragedy?
Here are five lessons every investor should take away from Madoff's scam:
Lesson 1. Diversify.
The biggest mistake many of the victims made was to put all of their golden eggs in one fraudulent basket: Madoff's Wall Street firm.
"Although it seems more convenient, it is never a good idea to have all of your money with any one adviser or firm," says Ann Logue, a financial analyst and author of Socially Responsible Investing for Dummies.
"Even assuming that Madoff was legit, he could have had a bad year. Then where would everyone be?"
Lesson 2. Don't rely on recommendations.
Madoff acquired many of his clients through recommendations of his existing investors. Even if your mom or dad or best friend or high school softball coach swears by an investment adviser, be skeptical.
Be especially wary if you need a special introduction to be considered as a client. Or if you're told the adviser only accepts a certain caliber of investor and being allowed to open an account feels like you're joining an exclusive club.
Creating the illusion that you're being offered something that's reserved for a privileged few is common to many frauds, because it's effective at pulling victims through the door.
Lesson 3. If it's too good to be true, it's probably not true.
Madoff claimed to make 10% to 20% a year. Year after year. In good markets and bad.
That's simply not possible. Warren Buffett, considered by many to be the greatest investor of our time, couldn't consistently earn those kinds of returns.
Madoff claimed to be using what traders call a split-stake conversion strategy, which involves buying a basket of stocks that closely correlate to a market index and then using futures contracts to hedge against losses.
Yet, other investment advisers repeatedly asked how Bernie Madoff could make so much more money than anyone else using split-stake conversion and even his own clients repeatedly wondered, "How does he do it?"
Lesson 4. Ask questions. Get answers.
"The interesting thing about the Madoff case is that when people asked questions, he refused to answer them," Logue says. "That should have been a big red flag."
Indeed, Madoff created a cult-like following among his investors by refusing to explain his trading strategy, inferring that it was just too complicated for a lay person to understand and fostering the false aura that he was just smarter than everyone else.
Like many accomplished con artists, Madoff cultivated the notion that even asking about the source of his outsized returns was rude, bordering on disloyal.
When investment advisers tell you to stop worrying and just put your money in their hands, that's exactly when you should worry and take your money out of their hands.
Lesson 5. Have a reputable third party hold your investments, do the trading.
Let your adviser decide what stocks and bonds to hold in your portfolio.
But hire a well-known broker such as Charles Schwab or Fidelity to serve as the custodian for your investments, execute trades and issue statements.
"In the Madoff situation, all of his clients' money was accounted for only by Madoff's firm," says Mike Davis, president of Resource Consulting Group, a Florida financial planning and investment advisory firm.
Investments were held by Madoff's wealth management operation, which was at the heart of the scam, and trades supposedly were handled by Madoff's brokerage.
Clients got as many as 30 or 40 statements a month detailing trades and listing all of the stocks and bonds in their accounts.
They were totally fictitious -- and critical to perpetrating the fraud.
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