December 17, 2008, 6:00 am

Lessons from the Madoff affair

by: The Financial Blogger    Category: Investment, Market and Risk
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By now, unless you have been living in a cave somewhere, you have probably been hearing about the Panzi scheme ran by Bernie Madoff a whole lot more than you’ve heard about anyone else in the past week. In case you did just spend some time in a cave, Madoff ran a fund through a company named “Madoff Investment Securities”. The company ran a scheme where it took in some investments initially, then started publishing results, very good ones of course. The numbers were pure fabrications in many cases it seems. But with good returns came more investments so that any investor wanting to receive some of his profits could receive them. The whole affair works well until you get more requests for redemptions than money you are able to receive in new investments.

With high and consistent returns, few investors actually made such requests. That lasted until the recent credit and financial crisis created liquidity needs for many investors and left the fund with insufficient funds and assets to cover the redemption requests which led to the discovery of the massive fraud. Estimates are very wide but it seems the fraud could be of up to $50 Billions!

Among the victims are banks, investments firms, pension funds but also many smaller individual investors. Of course, there will be a lot of blame to spread around. Many of the following actors will surely be blamed:


US government


-Lack of regulation in hedge funds

-etc, etc

But to me, there is still not enough accountability in the investors. I really do feel for the investors who had all of their savings almost wiped out in this scheme. But then I wonder how they could have possibly have been so naïve…So a few lessons:

1- Diversification is essential: No matter how big or how small your portfolio, you DO NOT want to have all of your eggs in one basket. Sure, it might be the best fund in the world, the biggest opportunity. But fraud, trading problems, strategy backfires, etc happen and there is no excuse for having everything invested the same way.

2- Check things yourself: No matter how much you dislike finance and the whole investment field, everyone should spend some time every month looking at what is going on. You may have a financial advisor that does most of the work, but you should still be able to question the moves made and the investments you hold. Financial matters are too important to completely ignore or to trust someone else 100%.

3- Make sure you are informed: Be sure you know what is happening in the markets, in the news, even if it is just through reading a few newspapers a month, so that you are aware of the type of thing that is going on. Such frauds have been happening for years now so many investors had seen this one coming…

4- Beware funds of funds and other such schemes: Funds of funds and other such investments have a major disadvantage as you do not have access to the specifics of your investment. Most of the investments made in the Madoff funds were made through this manner so investors did not actually know that they were buying this fund. You should try to have a portfolio that is as transparent as possible…

5- There is no Free Lunch in Finance: If anyone shows you great returns years after years and promises you the milk, the cow and the farmer’ smile at the same time, walk away! Forget about the finance gurus and get back to the basic: a good asset allocation, periodic investment and keep up with the same strategy no matter what happens!

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You spelled Ponzi “Panzi”. This was an interesting article.

If it looks too good to be true, it usually is.
It’s just amazing that even sophisticated investors got duped.

This is one of many scams that is going to be exposed over the coming year. Even the richest and wealthiest are subject to scams like the rest of us. I see a movie on this whole saga emerging soon as well.

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