Lessons From the Tom Petters and Bernie Madoff Scandals
By Keith Tufte
Tom Petters (alleged) investment scheme is estimated to have cost his investors $3 billion in losses. Bernie Madoff's $50 billion Ponzi scheme has just blown up over the past few weeks. The $50 billion Madoff losses are the largest fraud-related investor losses in history by a wide margin. What lessons can investors learn from these recent giant fraud schemes to protect themselves in the future so they aren't duped as well?
1. If it sounds too good to be true, it probably isn't true. Returns that are well above the market or that are amazingly consistent through any type of market demand lots of questions. Be skeptical. Petters was supposedly promising some investors big returns every 90 days. That is just not realistic and doesn't make common sense. Why didn't he just give investors a steady 12% return per year (or borrow at 6%-8%) and keep the rest for himself if it was such a great business/investment? Madoff supposedly produced equity returns that were amazingly consistent at +1% per month regardless of how much the stock market rose or fell during the month. Again that's too good to be true.
2. Don't chase returns. You are likely late if you are chasing great recent historical returns.
3. Risk is always highly correlated to returns. There is no free lunch. Be wary of guaranteed returns and/or promises of above market returns. If your manager is producing great above market returns, he is probably taking above average risk to get there. Be skeptical.
4. Wealthy people are often not any smarter or more ethical than regular people. Both of these investor frauds had lots of wealthy, smart people and companies as investors. Greed is a universal emotion that may even be stronger for wealthy people. The more you have, the more you want even more. Sometimes the rich are the "dumb money".
5. Trust, but verify. Ronald Reagan said it best. Some people who did their homework on Petters and Madoff decided not to invest. Get verification from third parties, referrals, background checks, brokerage statements from an un-related custodial brokerage firm. Do your due diligence to check things out or have an advisor you trust do it for you.
6. Beware of conflicts of interest. Petters was paying his associates million dollar bonuses to keep them happy and going along with the scheme. Bernie Madoff had his sons working for him and his brother-in-law was his accountant. Madoff owned the investment firm and the brokerage firm that was doing all the trades so it was much easier to fudge the numbers. Is the financial incentive of your investment manager/advisor aligned with your interests? Always? Ask the question.
7. Make sure your investment manager is using a separate, independent, and well-known broker/dealer as the custodian for your assets. Make sure your assets are at a custodian firm who is independent of the investment manager. Is it a custodian firm you have heard of? Madoff owned and ran both and therefore there was no outside party to verify things. The fox was guarding the henhouse. Madoff's client statements did not come from an independent custodian such as Fidelity, Schwab, or TD Ameritrade. They were from Bernard L. Madoff Investment Securities, LLC. Madoff himself controlled what the statements said. Did Petters even use a custodian? Make sure you get regular statements from the independent custodian investment firm, not just from your investment advisor.
8. Never write checks or send deposits directly to your investment advisor. They should be written to the investment advisor's firm or preferably directly to the custodian firm that is holding the assets.
9. Diversify. Don't put 100% of your investment in one hedge fund strategy like many Petters and Madoff investors did. They likely did this because they were getting such great returns (for a while) there. Now they are completely wiped out.
10. Watch your risk levels. Again many investors had most or all of their money invested with just one hedge fund strategy (Petters or Madoff). That is too risky for any investor.
11. Get your investment agreement in writing. It is smart to have an Investment Policy Statement (IPS) that outlines your investment strategy and parameters in writing. You should also have the investment agreement between you and the investment manager in writing.
12. Hedge funds can be risky. They are mostly unregulated, often secretive, expensive, and usually not transparent. You often don't know how much risk they are really taking.
13. Don't invest with a money-manager just because of their reputation. Check them out. Do some due diligence. Understand their strategies and make sure they make sense for you. Business success and social prominence doesn't ensure safety or soundness in investments. They also don't ensure the highest ethical standards.
14. Use common sense. Did it make sense that Petters could buy electronics from Sony and then sell it to Wal-Mart and make big returns? I don't think so. Wal-Mart is a smart company with big buying power and smart purchasing agents. Petters was in some of the toughest businesses in the world (electronics, airlines, Polaroid) and was supposedly making huge money in them? Madoff made 1% each month in stocks when the market was down big or up. Does that make sense? How can he do that? Ask the questions.
15. Don't invest in things you don't understand. This is one of the best rules of investing. You should understand the structure of the firm you are working with, the investment philosophy, and the investment process. I'm sure most of Madoff's investors had no idea what his "split strike conversion" equity strategy was. How many investments do you own that you don't understand?
16. Avoid "secretive" and "unusual" investment strategies and managers. Demand transparency. Ask lots of questions. Read through your brokerage statements carefully to make sure you understand what is going on. Petters and Madoff were both secretive about how they were producing these great returns and discouraged investors from asking about their "proprietary" strategies. Madoff would toss investors out who asked too many questions.
The Petters/Madoff scandals are another reason for investors to lose confidence and trust in the financial markets. Most investment advisors and money managers are good and honest people.
| Keith Tufte Article Source: http://EzineArticles.com/?expert=Keith_Tufte |
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