Charitable organizations and state funds often have substantial endowments that are run by under-qualified people, because the charities and states don’t pay enough; these people can also be seduced by the well-connected, and are not necessarily competent to assess the details of how investment returns are generated.
Ponzi schemes were given an enormous boost by the advent of derivatives and trading desks in the 1980s. Whereas the doziest country club member or charitable trustee has some idea of how bonds or stocks make money, even many financial professionals are a bit hazy about derivatives and trading profits. Hence, Madoff was able to maintain a plausible smokescreen over his activities. Since private partnerships do not have the same disclosure rules as public investment funds, he had no need to disclose the precise trades by which profits were made, nor any details about his methodology.
The increased complexity of modern investment does not however excuse the gullibility of professionals such as those who manage hedge funds and “funds of funds,” both of which invested in Madoff’s schemes. These people are paid inordinate amounts of money to provide superior investment returns to individuals and institutions that – perhaps naively – believe that by paying excessive management fees, one can obtain truly superior investment management. They should not be able to claim inexperience, a lack of an understanding of complex investment products, or even a lack of intelligence, since most of these people have degrees from top schools.
Warning Signs to Watch For
In reality, professional investors were infected with the “get-rich-quick” fever that reached epidemic proportions during the 13 years of easy money and lax regulation. As a result, these “professional” investors failed to exercise their “due diligence” in investigating how Madoff’s investment operation made money before investing in it. To the extent they were investing other people’s money, they deserve to be sued for failing in their fiduciary duty. To the extent they were investing their own money, they deserve to have their fancy degrees removed at some suitably ignominious ceremony, for crass stupidity and incompetence.
As for the lessons the rest of us should take away from this event, allow me to say that there are several:
- First and foremost, don’t invest in something you don’t understand, just because the promoter has good connections. If he can’t explain to you in terms you can understand how he makes money, there’s probably something fishy involved.
- Second, don’t believe the hype about "alternative asset classes" – most of it is just jargon designed to remove extra fees from you.
- And third, if you obey the three cardinal rules of investing – diversify, buy over an extended period, and research well what you intend to buy – you will probably do as well as most professionals, and far better than that substantial minority of professionals who are in reality utter incompetents.
One great consolation about this recession: Ponzi schemes do much less well in recessions, because people are more suspicious. Ponzi flourished in the modest hot-money boom after World War I and Madoff made hugely more money in the correspondingly larger bubble from 1995-2008. Recessions, unlike bubbles, are relatively safe times to buy investments, because the investments themselves are cheaper and there are fewer crooks around.
