Management risk in the money business

News of the Madoff Fiasco hit this weekend. Bernie Madoff founder of Bernard L. Madoff Securities Inc., based in New York City was apprehended by federal investigators. Founded in the 60's Madoff's firm boasted an impressive list of A-clients both high net worth individuals and institutional accounts. For years and years, Madoff and company paid clients an incredibly stable dividend of 1-1.5% a month, almost without fluctuation. When fixed income rates went below 3% over the past few years, and equity dividends were less than 2%, Madoff continued to pay out 15% a year. Miraculously. No one knew how this could be. It defied logic. Sadly so long as they where making out like bandits, few investors asked questions.
When Madoff was asked to explain his approach and his success, he spoke in circles of black box, gobbley gook and secrecy; but always with calm and confidence. Watch this YouTube clip of Madoff speaking in 2007. As you watch, keep this time-worn advice in mind: if you cannot understand what a person is doing with your money–don't sign up. If returns seem too good to be true–they likely are.

This article by one of the long time Madoff investors speaks honestly about the lure of easy money:
“I think everyone knew the call would come one day. We all hoped, but we knew deep down it was too good to be true, right? I mean, why wasn't everyone in on this game if it was so strong and steady? We deluded ourselves into thinking we were all smarter than the others. When it came to the investment game, we had it figured. And what was the game anyway? The way it was vaguely described to us was that the “New York people” had a system whereby they placed a series of instant trades — at once with futures, currencies and stocks — and out of this magic recipe fell a tiny 1% guaranteed, no-risk profit for the group. You do that 20 times a year, take away management fees and, voilà, a steady 15% return. Man, these guys were good.
“But of course the call did come, as it always does with such things. It was not an ordinary Ponzi scheme we were all part of; it was the biggest in the history of the world, valued at some $50 billion. Lucky us. Small investors, institutions, hedge funds, global banks, pension funds — all fell victim to usual suspects: a smooth huckster and greed.”
See How I got screwed by Bernie Madoff.
For my part I loath guys like Madoff. He was the head of the NASDAQ at one point, he was New York elite. He was one of those rich guys that are respected largely because they are super rich. Apparent wealth inspires others to awe and respect. He is assumed to be brilliant. And his arrogance, greed and sociopathic ego make my job harder.
First of all, his actions work to smear all trust professionals with doubt and deceit. They taint all trustees and fiduciaries with suspicion. On a broader level they teach us all that it is dangerous to trust and believe in the integrity of others.
But more specifically, guys like Madoff virtually ensure that honest money mangers are sure to be fired by some clients at some point every cycle. Why? When compared to a fraud, honest investment results can sometimes look boring and insufficient to unsuspecting clients. Sometimes, as in this case, it can take years before the “truth’ comes out. Many people typically do not see the need for valuable risk management until after disaster has struck.
Even in the absence of fraud, the most reckless money managers frequently look the wisest near the peak of a market. Buffett has said, you can only tell who has been swimming naked after the tide has gone out. I am reminded of a few clients that fired my firm in 2006-2007 because we had gone defensive and were focused on avoiding the inevitable market collapse that was coming. I remember several people pulling their accounts and telling me that we were clearly out of step. The fact that they have doubtless lost vast sums elsewhere now is no comfort. We are not vindictive. We are inspired to teach people the truth about money even when it means they won’t hire us or even if they fire us, lured up the street by hyperbole.
Human beings can learn wisdom from these experiences. They can trust and be trusted. And so long as we have clients who “get it” we honest folks will be here to serve them. And in the end, guys like Madoff will not crush our faith. They will not win.

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6 Responses to Management risk in the money business

  1. Anonymous says:

    If it sounds too good to be true … After listening to and reading comments from many so called analysts after the big move in equity markets today, I can see how investors get caught up in all the hype. I can't believe the sudden optimism about how confidence has been restored and the fomc has saved us all. If it was that easy why didn't they do it months ago and sidestep the recession altogether. It always amazes me that people only hear what they want to. Many analysts say consumer spending will get us out of this mess as it will get the economy going. Isn't this what got us into the problems to start with. How about saving and paying down your mortgage? I hope it's the beginning of a new trend in the markets but I'm not speculating on it being so. Great blog Danielle and I enjoy reading your replies as well as those from your informed readers.

  2. Anonymous says:

    Hi Danielle,
    Today the Fed lowered rates to historic lows. They have been doing this, and using various other tactics for quite a few months now. I am beginning to wonder why these measures are not having any effect? Is this a lag factor and we have yet to see the effects of these measures? The US treasury has also been active, also to no avail. I hear on tv from various analysts and economists that the housing problems need to be fixed in order to get this mess under control. But if banks are not lending to one another and are too concerned about fixing their own problems. Then how are people to get loans to not only purchase excess housing inventory? But to start new projects and ultimately begin the next economic expansion? It just feels like we need a whole lot more pain before we see things turn around. I hope I am on the right track and appreciate your insight. These are fascinating times. Thanks

  3. Anonymous says:

    Hi Danielle,
    I have read your book and have learned a lot by also reading this blog. It almost seems like we are living in the twilight zone. It is unthinkable that someone could get away with this for so long.
    As you have stated that you are a realist, do you think a global economic collapse is a possiblity in the not too distant future and if so, how do you think this would affect us in Canada? I hope it never comes to this but there are a lot of alarming things happening with all these bailouts, interest rate cutting, etc.
    Thanks for your time and insight you put into this blog.

  4. Anonymous says:

    A financial collapse would hurt everyone including Canada, but I do not expect a collapse. I do expect a long slow recovery where people build up the savings rate from the present 2% to 10% over the next few years. This will all help to set us up for the next secular expansion some 7 to 10 years from now, but over the next 7-10 years it will mean muted growth and a drastic change in consumer behaviour.

  5. Anonymous says:

    I certainly hope you are right about the future spending behaviour. Unfortunately, the rampant consumerism that had for so long characterized North America has been exported to the rest of the world. The change would have to be global.

  6. Anonymous says:

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