Lessons Learned from Madoff - How to Be a Better Investor

Lessons Learned from Madoff - How to Be a Better Investor

by Richard Taylor on Apr 23, 2021

Stock Markets & Investing

Reading Time: c.6 mins

Last week, as you no doubt heard, Bernie Madoff passed away, bringing a form of closure to the notorious scandal associated with his name. That is, the biggest Ponzi Scheme in history.

As I reflect on Madoff, I am conscious that I tell our clients that via our strategies and the philosophy we employ, they can never fall victim to such a scheme.  As a result, I decided that I wanted to write something relevant to our clients, and more broadly, investors like our clients. More specifically, I want to share the lessons that can be gleaned and the actions that can be taken to avoid falling victim to a similar fraud.

Because, of this we can be certain, there are Ponzi Schemes under way right now and there will many that follow. 

In my opinion, the reason that Madoff’s massive fraud existed for so long was mostly due to two factors:

  1. He had a network of fabulously wealthy investors to tap into who trusted him completely (because of his reputation within the financial industry for his other achievements) and, unbeknownst to them, repeatedly bailed him out (by injecting capital into his “funds”) when he was about to run out of cash. 
     
  2. His investors, even as sophisticated, experienced and successful as they were, wanted to believe that they could enjoy consistent equity-like returns without the accompanying volatility and they were prepared to overlook the red flags Bernie’s fund exhibited in order to sustain belief in the myth. 

The second point is most important and relevant for our purposes, because it is universal, so I will focus on this. 

We are all susceptible to this and we are preyed upon as a result – by fraudsters running Ponzi Schemes and more often by financial institutions dreaming up legitimate but questionable (and always expensive) strategies and products.  

Bernie’s funds offered consistent returns of 10%-12% per year, every year. There was no volatility. The stock market plummeted 10%, 20% even 30% - temporarily it needs to be stressed, although still highly unpleasant in the moment – but their money with Bernie kept delivering 10% -12% come rain or shine. 

Strikingly, this return is not materially different to the long-term return offered by the S&P 500, which Dimensional Fund Advisors tell us has, over the last 90 years, delivered an average annual return of 10% p.a. 

So, if investors can generate 10% p.a. from low cost, transparent S&P 500 trackers (e.g. ETFs) from one of the largest investment companies in the world audited by the biggest accountancy firms in the world, why would they instead choose to invest with a tiny outfit, in an opaque fund audited by a one man band for an additional meagre additional 2% p.a. return?!?

Because they didn’t have to suffer through the inevitable market twists and turns and the accompanying existential stress that accompanied (obviously what they ultimately had to suffer through was much worse, but they weren’t to know this, although some should definitely have considered it). 

Because, as the same Dimensional study tells us, whilst the S&P 500 (and its predecessor indexes) has delivered an average of 10% p.a. over the last 90 years, in only 6 of those years was the return within 2% of that 10% . In other words, in only 6 years was the return for the year between 8% and 12%. In all the other 84 years it was outside of that range, often wildly so – often it was negative for the year, sometimes VERY negative.

 Madoff’s investors believed that they were getting equity returns without equity volatility. They wanted the returns without paying the price, but the ultimate price they paid was so, so much higher. 
I’m sure the lesson here is obvious by now – if you want/need equity returns (and nearly every “normal” investor hoping to enjoy a multi-decade retirement accompanied by continually rising prices does) then you need to be prepared to endure the volatility and the accompanying emotional stress and anxiety this involves (which can and should be diminished by working with a good financial planner). 

Applying this lesson will not just help you avoid complete scams, such as Ponzi Schemes, but there is a never-ending stream of legitimate financial products that come to the market each year promising to deliver equity-like returns without the volatility, including structured products, hedge funds, absolute return funds etc. In my experience these products are usually high priced and ultimately benefit the provider more than the investor. Most under-perform the equity market – sometimes substantially – and in some cases they blow up altogether.

 If you want equity returns, invest mostly in low-cost equity trackers and you remove all these risks. The cost is volatility, but surely this known cost that we have never failed to overcome (every decline thus far has been temporary) is a better price to pay than the unknown costs of other strategies?!

How this relates to T&T strategies

When I am explaining our investment philosophy to clients and potential clients I will often say something along the lines of: 

“We are not gambling. This is not black or red at the casino. We are not betting on any one stock or sector or country or continent. We are not betting on any one fund or fund manager. You are never going to get a call from us saying “this company has gone bust or this fund has gone down and all your money with it.” In other words, you are never going to make a killing in any one thing, but you are never going to get killed by any one thing either.”

We manage this risk by mostly plugging our clients into global stock markets, investing them across thousands of stocks. We utilise some of the largest and most trusted institutions – such as Vanguard – to help us do this. We invest in passives to keep the costs to a minimum (one of the ETFs in our US strategies costs 0.07% p.a.) and we do not rely on the genius of one manager to pick the winners and avoid the losers.

We do no eschew active management altogether, but we limit our exposure to it allowing our clients to enjoy the benefits (i.e. outperformance) when we get it right, but if/when the manger enters a period of underperformance (or something altogether more sinister – e.g. the Woodford scandal in the UK), our clients cannot be undone over it (to the extent that some Madoff investors were, some of whom apparently invested all of their investible wealth in his fund – they put all their eggs in one opaque basket). 

It isn’t easy running our strategies. We work extremely hard to keep them massively broad, but extremely simple. We avoid anything and everything opaque. We tell clients the truth about volatility – which is that is it an unavoidable facet of investing and whilst we don’t deny the emotional cost of volatility we put it in the historical context that thus far every market decline has been temporary - that we have never failed to not recover - and that the known risk of volatility is preferable to the myriad of unknown risks (and poor track record) associated with the alternatives. 

We have a very clear philosophy that we apply to all of our strategies, regardless of the platform or currency, and a track record of risk appropriate results. The passing of Bernie Madoff caused me to pause and reflect upon our approach and examine it through the prism of his fraud and his investors’/victims’ mindsets and motivations and I am more convinced than ever that we are managing our client’s money appropriately and in their best interest. 

And by appropriately, I mean delivering appropriate returns for the level of risk that they are prepared and/or need to take without risking their money to any singular calamity or outright fraud. But that does mean being candid and always telling the truth about money and investments, as opposed to what people sometimes want to hear and we are also totally OK with that. 

Taylor & Taylor Financial Services USA LLC is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.