Tuesdays With Bernie – Some Life (and Investing) Lessons From the Madoff Affair
By Clark Winter
Chief Investment Officer
SK Capital Partners
A friend of mine recently told me that a friend of his lost some money with Bernie Madoff –not as much as some, but more than others. What struck me about the loss, after a bit of conversation, was that much of what has been written about the Madoff scandal has shed little light on why smart investors make mistakes, which therefore opens the possibility that such mistakes might be made again. My analysis won’t be the last word on Madoff –there are apparently four post-conviction salacious books in the works and the movie rights are sure to be sold – but for now, this is what I can offer.
First, let’s start with the now often asked question, “Where was the SEC in all this?” Critics of the agency, of regulatory failure or of unbridled capitalism, somehow have the belief that the SEC ought have acted on complaints about Madoff earlier, and that the failure of several investigations to uncover wrongdoing at the brokerage arm of his investment company was somehow negligence, or worse. Lawsuits will decide the SEC’s degree of culpability. But what is also true is that even a massive hiring round by the SEC would not have helped much. The securities industry has not merely mushroomed; it has exploded in size, scope and globality. In the U.S. alone, where there were 3,000 or so equity issues a generation ago, there are now over 7,000. A couple of hundred mutual funds have proliferated to thousands. Hedge funds? From a handful to thousands. Private equity funds? Ditto. Now, multiply that by the dozens of countries that have come onto the financial map since the early 1990s, opening stock exchanges and floating equity and bond issues, and launching their own funds. The array of investment opportunities boggles the imagination, and far outstrips the ability of even the savviest regulators to keep on top. I’m not exonerating the SEC, but the huge expansion of investment possibilities created a monster that no agency can pretend to regulate effectively.
It also created vast mediocrity that encourages cheating at every turn. Do you really believe that there are thousands of good money managers? Or thousands of good CEOs, or thousands of hedge fund geniuses? There are only a handful of star athletes, men and women who put themselves through rigorous training to reach the pinnacle of their sport. There are only a handful of doctors and lawyers who are worthy of the fees they command. Yet in the investment arena, performance statistics and benchmarks can be easily manipulated, so that almost everyone looks like a star at one time or another.
Mediocrity aside, investors fell prey to the Madoffs of the world because they were told, educated, to the belief that they themselves were not smart enough to manage their own money. An entire industry was constructed to persuade investors that there was a class of individuals who were “experts” in the field of investing. These folks, armed with asset allocation formulas and efficient frontier theory, gilded the common sense notion that prudence dictates risk mitigation via a bit of diversification and turned it into a body of mathematical work that was impenetrable to even sophisticated investors and their surrogates.
And their surrogates. Just as it is difficult to find genuinely talented investment managers, the same thing is true for the gatekeepers and private office managers who shepherd the wealth of the wealthy. Even when such people are honest – and the vast majority are both honest and conscientious – it is difficult for them to both meet the demands of their clients and grow their clients’ money. Having to do both simultaneously, many take the more easily traveled path of laying money off with a firm with a good track record. One of the things my friend’s friend told him was that his wealth advisor had been earning him a steady 12% to 15% per year, which he thought was a legitimate return. With markets bouncing up and down, it would take someone with the genius of an Einstein and the reflexes of a teenager with a video game controller to stay on top of enough markets and so many diverse investments in order to keep such returns going indefinitely. Or fraud, as in Bernie Madoff’s case.
Which brings us to the next point. Commonsense tells us that if something is too good to be real, it usually isn’t. Yet even as interest rates were yo-yoing, and stock markets were becoming increasingly volatile, Bernie chugged on. Shouldn’t personal alarm bells have begun to go off? The Irish statesman and philosopher Edmund Burke once wrote that “All that is necessary for the triumph of evil is that good men do nothing.” The people who lost money to Bernie Madoff fit that description perfectly. My friend’s friend is a smart man. His family is well-educated, and made their fortune through intelligence and hard work. Their charitable giving is extensive. They lead a remarkably simple life considering their wealth. But their desire to have more to give more led them not to question. Their trust in experts, coupled with their belief in their own intelligence, told them that good returns trumped good judgment.
Are there lessons to be learned? Several come to mind. The first is, “There’s no such thing as risk free.” Every investment carries within it the possibility of loss. An advisor who tells you otherwise should never be trusted. An advisor who shows you a private placement memorandum or a red herring with lots of lawyerly warnings and then tells you, “Don’t worry. Those words are there just to scare away the less sophisticated,” or uses other dismissive words, should be dismissed. Even Treasurys carry some risk, the Sharpe ratio and Bill Sharpe’s Nobel Prize notwithstanding. The investing world has always had its perils. It’s just that now, with the economy in trouble, the perils appear more visible.
The second lesson is, “Always kick the tires.” Other than people on Wall Street who made fortunes from fees and bonuses, most of the world’s wealth comes from the direct participation of its creators. You made the money you have to invest by showing up at your business every day, and by mastering every detail of your enterprise. When did your golf game become more important than your money? To be passive about investment management is to be contemptuous of what brought you to your exalted state in the first place. A generation or two ago, when money was more difficult to come by, and the business heroes were not the people who discovered the secrets of leverage, but rather, were people who built great enterprises, investments weren’t made until someone went out and kicked the tires, or pored over the books, or thoroughly weighed the value of an investment and understood the pitfalls. Sure, sometimes people made poor choices. But it wasn’t because someone promised them a certain return.
The third lesson is, “Expect the unexpected.” There is an old Yiddish proverb that should always be kept in mind: Translated, it says, “Man plans. God laughs.” Between 2005 and early 2007, the VIX, a measure of stock market volatility, was running at historic lows. That should have been a signal that investors had forgotten that the potential for loss is omnipresent. But seeing their ever-improving portfolios, too many investors, instead of asking when the party would end, ordered more champagne and caviar, without considering that the due bill was growing. You only had to pick up the morning paper to realize that the global economy was growing shakier every day, and that above average returns of the kind that Bernie Madoff delivered could not be sustained. But his victims, as well as the millions of ordinary investors who were clobbered by sharply declining stock markets around the world, planned their lives – their futures, their retirement, their lifestyle – on an ever rising-stock market, and an ever-improving real estate climate. Life – and investing – is not a straight-line event.
The fourth and final lesson is, “Save yourself.” To circle back to the beginning, the SEC and all the regulatory bodies on the planet, and all the regulation czars likely to be appointed, cannot save you from yourself. You are your own first line of defense, not some regulator in Washington. If you are going to do more than sock your money into a mattress, or bury it in the back yard, or turn it into a sack of diamonds you can carry with you, it is up to each and every investor to take responsibility for the investments they make. Ask questions. If you don’t like the answers, or if the tone is too soothing or too deprecating, don’t write the check. Don’t write the check if someone pressures you, or if the investment is not transparent enough or understandable enough. It’s your money, so it’s up to you to protect it. Not the Bernies of the world.
© 2009 Clark Winter
By Clark Winter
Chief Investment Officer
SK Capital Partners
A friend of mine recently told me that a friend of his lost some money with Bernie Madoff –not as much as some, but more than others. What struck me about the loss, after a bit of conversation, was that much of what has been written about the Madoff scandal has shed little light on why smart investors make mistakes, which therefore opens the possibility that such mistakes might be made again. My analysis won’t be the last word on Madoff –there are apparently four post-conviction salacious books in the works and the movie rights are sure to be sold – but for now, this is what I can offer.
First, let’s start with the now often asked question, “Where was the SEC in all this?” Critics of the agency, of regulatory failure or of unbridled capitalism, somehow have the belief that the SEC ought have acted on complaints about Madoff earlier, and that the failure of several investigations to uncover wrongdoing at the brokerage arm of his investment company was somehow negligence, or worse. Lawsuits will decide the SEC’s degree of culpability. But what is also true is that even a massive hiring round by the SEC would not have helped much. The securities industry has not merely mushroomed; it has exploded in size, scope and globality. In the U.S. alone, where there were 3,000 or so equity issues a generation ago, there are now over 7,000. A couple of hundred mutual funds have proliferated to thousands. Hedge funds? From a handful to thousands. Private equity funds? Ditto. Now, multiply that by the dozens of countries that have come onto the financial map since the early 1990s, opening stock exchanges and floating equity and bond issues, and launching their own funds. The array of investment opportunities boggles the imagination, and far outstrips the ability of even the savviest regulators to keep on top. I’m not exonerating the SEC, but the huge expansion of investment possibilities created a monster that no agency can pretend to regulate effectively.
It also created vast mediocrity that encourages cheating at every turn. Do you really believe that there are thousands of good money managers? Or thousands of good CEOs, or thousands of hedge fund geniuses? There are only a handful of star athletes, men and women who put themselves through rigorous training to reach the pinnacle of their sport. There are only a handful of doctors and lawyers who are worthy of the fees they command. Yet in the investment arena, performance statistics and benchmarks can be easily manipulated, so that almost everyone looks like a star at one time or another.
Mediocrity aside, investors fell prey to the Madoffs of the world because they were told, educated, to the belief that they themselves were not smart enough to manage their own money. An entire industry was constructed to persuade investors that there was a class of individuals who were “experts” in the field of investing. These folks, armed with asset allocation formulas and efficient frontier theory, gilded the common sense notion that prudence dictates risk mitigation via a bit of diversification and turned it into a body of mathematical work that was impenetrable to even sophisticated investors and their surrogates.
And their surrogates. Just as it is difficult to find genuinely talented investment managers, the same thing is true for the gatekeepers and private office managers who shepherd the wealth of the wealthy. Even when such people are honest – and the vast majority are both honest and conscientious – it is difficult for them to both meet the demands of their clients and grow their clients’ money. Having to do both simultaneously, many take the more easily traveled path of laying money off with a firm with a good track record. One of the things my friend’s friend told him was that his wealth advisor had been earning him a steady 12% to 15% per year, which he thought was a legitimate return. With markets bouncing up and down, it would take someone with the genius of an Einstein and the reflexes of a teenager with a video game controller to stay on top of enough markets and so many diverse investments in order to keep such returns going indefinitely. Or fraud, as in Bernie Madoff’s case.
Which brings us to the next point. Commonsense tells us that if something is too good to be real, it usually isn’t. Yet even as interest rates were yo-yoing, and stock markets were becoming increasingly volatile, Bernie chugged on. Shouldn’t personal alarm bells have begun to go off? The Irish statesman and philosopher Edmund Burke once wrote that “All that is necessary for the triumph of evil is that good men do nothing.” The people who lost money to Bernie Madoff fit that description perfectly. My friend’s friend is a smart man. His family is well-educated, and made their fortune through intelligence and hard work. Their charitable giving is extensive. They lead a remarkably simple life considering their wealth. But their desire to have more to give more led them not to question. Their trust in experts, coupled with their belief in their own intelligence, told them that good returns trumped good judgment.
Are there lessons to be learned? Several come to mind. The first is, “There’s no such thing as risk free.” Every investment carries within it the possibility of loss. An advisor who tells you otherwise should never be trusted. An advisor who shows you a private placement memorandum or a red herring with lots of lawyerly warnings and then tells you, “Don’t worry. Those words are there just to scare away the less sophisticated,” or uses other dismissive words, should be dismissed. Even Treasurys carry some risk, the Sharpe ratio and Bill Sharpe’s Nobel Prize notwithstanding. The investing world has always had its perils. It’s just that now, with the economy in trouble, the perils appear more visible.
The second lesson is, “Always kick the tires.” Other than people on Wall Street who made fortunes from fees and bonuses, most of the world’s wealth comes from the direct participation of its creators. You made the money you have to invest by showing up at your business every day, and by mastering every detail of your enterprise. When did your golf game become more important than your money? To be passive about investment management is to be contemptuous of what brought you to your exalted state in the first place. A generation or two ago, when money was more difficult to come by, and the business heroes were not the people who discovered the secrets of leverage, but rather, were people who built great enterprises, investments weren’t made until someone went out and kicked the tires, or pored over the books, or thoroughly weighed the value of an investment and understood the pitfalls. Sure, sometimes people made poor choices. But it wasn’t because someone promised them a certain return.
The third lesson is, “Expect the unexpected.” There is an old Yiddish proverb that should always be kept in mind: Translated, it says, “Man plans. God laughs.” Between 2005 and early 2007, the VIX, a measure of stock market volatility, was running at historic lows. That should have been a signal that investors had forgotten that the potential for loss is omnipresent. But seeing their ever-improving portfolios, too many investors, instead of asking when the party would end, ordered more champagne and caviar, without considering that the due bill was growing. You only had to pick up the morning paper to realize that the global economy was growing shakier every day, and that above average returns of the kind that Bernie Madoff delivered could not be sustained. But his victims, as well as the millions of ordinary investors who were clobbered by sharply declining stock markets around the world, planned their lives – their futures, their retirement, their lifestyle – on an ever rising-stock market, and an ever-improving real estate climate. Life – and investing – is not a straight-line event.
The fourth and final lesson is, “Save yourself.” To circle back to the beginning, the SEC and all the regulatory bodies on the planet, and all the regulation czars likely to be appointed, cannot save you from yourself. You are your own first line of defense, not some regulator in Washington. If you are going to do more than sock your money into a mattress, or bury it in the back yard, or turn it into a sack of diamonds you can carry with you, it is up to each and every investor to take responsibility for the investments they make. Ask questions. If you don’t like the answers, or if the tone is too soothing or too deprecating, don’t write the check. Don’t write the check if someone pressures you, or if the investment is not transparent enough or understandable enough. It’s your money, so it’s up to you to protect it. Not the Bernies of the world.
© 2009 Clark Winter
