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3:55 pm - Tuesday May 31, 2016

The Madoff scheme – 4 Valuable Lessons

| Investing, Psychology | Rating: 4.5
by Numan

As always scandals present valuable lessons for us household investors

When I heard for the first time about the alleged $50 Billion “Ponzi scheme” by Bernard Madoff I was not surprised. Not to say I had anticipated such a scheme or would have known it to be one had I invested my money. It’s just that some things don’t change.

There are valuable lessons to be learned here, as always. Greed, lack of regulation and oversight, groupthink and more make up this sad story. The next outrageous financial scandal will probably consist of these key elements as well.

Short term memory is one of humanity’s banes. In this post I’ll explore my view on the lessons we can all learn from the current Wall-Street affair in the hope of implementing these, or at least some, the next time around.

If you haven’t had the chance to read how Madoff pulled this off there’s a good slideshow on cnbc.com.

This $50 Billion scam raises many questions. One of the most interesting questions in my opinion is raised in light of the fact Madoff accepted only the rich and able to his small circle of investors. These investors have the duty and all the means at their disposal to properly examine the investments they make. If the most professional can’t tell good investment from a scam how can we ever hope to?

#1 Groupthink, herd behavior or both

Groupthink is usually a phenomenon observed in groups in which group members try to minimize conflict and reach consensus without properly analyzing and evaluating ideas. The many investors in Madoff’s fund may not constitute a group for this purpose but they have without a doubt displayed characteristics of groupthink.

Much like a herd they all followed willingly without asking too many questions and without due diligence on their investment. This human behavior pattern, which is apparently deeply rooted in us does not serve well when it comes to good investing.

Time is a limited resource and our mind simply happily accepts the opportunity to conveniently rely on the work of others. The large French banking group, Societe-general, for example, held a due diligence of their own on Madoff’s fund deciding something doesn’t look right. All it took was a short analysis which apparently quickly revealed irregularities.

Such a due diligence would have quickly surfaced the fact the funds CPA firm consisted of 3 people operating from a one room office, according to some reports.
#2 Voluntary regulation takes one more boot to the head

What’s left of the concept of voluntary regulation is going through more abuse. Institutional investors have proven their inability and incompetence yet another time. Apparently we’ve been paying many fund managers to simply follow the trends and simple let themselves get carried away by the tide.

We can’t look to the credit rating agencies or to CPA firms for help as well. Credit rating agencies have too complicated models and interests and the CPA’s often refer to themselves as watchdogs rather than hound dogs meaning if they’ll see something they’ll report it but other than don’t get your hopes up.

Furthermore, private investment companies don’t fall under SEC regulation meaning they can do whatever they want.

#3 Obvisouly, if it’s too good to be true it probably is

Good deals scare me. Everything has a price and one should always understand the benefit for the other side. Only when I understand how the deal benefits the counterparty, either as a promotion, smaller yet positive margins etc., I calm down and go through with it.

We all get that sensation before we go though a really good deal or investment when we’re already counting our profits in our head. Our thinking is usually success oriented or otherwise we wouldn’t have accomplished anything but letting your head cool for a day or two before you go through the deal can’t hurt. If there’s value to the counterparty as well it can wait.

How could professionals really hope for 30 consecutive years of positive returns? One interesting view on this I read over the past week was that many investors knew something was fishy and hoped to gain on it as well. They hadn’t dreamed they were on the receiving end of this mega-scam.
#4 Diversification – goes without saying

Even the most solid appearing, ever-gaining, investments can be quite risky due to specific risks. Specific risks are the risks inherent in any single investment and its business as well as fraud, bankruptcy and others.

The only way to avoid specific risks (and to remain with the systematic risk) is by diversifying. This message is repeated so often I can’t really write about it anymore. Simply diversify.

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