In an exclusive interview with “Good Morning America” on July 10, billionaire investor Warren Buffet, CEO of Berkshire Hathaway, shared three pieces of investment advice. The advices are basic investment maxims. Coming from the “Oracle from Omaha”, they are a reassuring voice in this trying economic time. So I will discuss Buffet’s advices in relation to the Madoff Ponzi scheme.
Buffet’s advices are:
- If it seems too good to be true, it probably is.
- Always look at how much the other guy is making if he is trying to sell you something.
- Don’t go into debt.
I would like to dwell on the first point. I think this is the biggest lesson one can learn from Madoff. The annual returns of Madoff were out sized (any where from 10% to 20% a year and in some cases even higher) and consistent (year after year). This kind of performance should raise a giant red flag.
This meant that Madoff, until the collapse of his firm in December of last year, was a risk-free investment that also had a high rate of returns. This flied in the face of common sense and some of the most basic investment principles.
US Treasury debt instruments and various other cash instruments such as bank CDs are safe and risk-free, thus on the lowest spectrum of the risk scale. As of July 9, one-year Treasury annual yield is 0.54% and 30-year Treasury annual yield is 4.34%. Madoff essentially offered a ultra high yield investment that was also ultra safe. That should make anyone stop and do some checking before handing over the money.
At a higher spectrum of the risk scale is stock investing. Let’s look at S&P 500, an index of 500 large cap US stocks. The index was created in 1926 and is taken by many professionals as the proxy for the US stock market. Since its inception to 2002, the average return in investing in S&P 500 is about 12% annually. In these 76 years, you would not get 12% every year. Being a risky investment, the individual annual returns fluctuated wildly during these 76 years from minus 45% to positive 54%. So Madoff not only beat the market, he did so all of the time (year in and year out, month after month). It might be possible to find fund mangers who beat the market 10 years in a row. But inevitably the winning streak stops at some point. Why would Madoff be any different?
Warren Buffet has stellar investment results too. If you invested $1000 with Buffet in 1959, the accumulated value of that investment would be worth $25 million today, giving you an average 22.45% annual return over this 50-year period. But you would not get 22.45% every year. You would have 10% some years, -5% in some down years and 2% in some not so good years and 50% in some banner years. Over the 50-year period, the annual performances would average out to be 22.45% a year. In other words, real investments tend to have variability in annual and monthly results. This is the case with the two examples we have here – S&P 500 and Berkshire Hathaway. Moving away from stocks, even hedge funds exhibit fluctuated investment results from year to year. For example, with 2008 being a down year, most hedge funds suffered big losses in 2008. It is the lack of variability in annual returns that is the most troubling aspect about Madoff.
Madoff’s ultra high returns and ultra safe investment also flied in the face of the “no free lunch” principle of investing. This is also the “Eat Well, Sleep Well” adage for investment. This refers to the tradeoff between risk and return (reward). If you want to potentially eat well (gaining high return or reward from your investments), you must take on risk that may keep you from sleeping well at night. In contrast, if you want to sleep well (investing in risk-free investments), you will face the certain prospect of not eating well (low rate of return).
The risk-return trade-off described above implies that there is no free lunch. You can have your lunch (high returns) but you need to pay for it by accepting a higher level of risk. In choosing consumer goods, we tend to be skeptical of deals that are too good to be true. Why would investing be any different, especially when you are investing a substantial sum of money?
Some Madoff investors probably explained that Madoff must know what he was doing. He had the secret sauce that others did not have. After all, didn’t he use a proprietary strategy based on the split strike conversion strategy?
There was no secret sauce. Professionals in the investment world are vultures to a large extent. If they see something lucrative, they all want to get in on the act. In fact, Frank Casey, former vice president of marketing for Rampart Investment Management, got wind of Madoff’s fantastic results in the late 1990s and wanted to look for the same secret sauce. He and his colleague Harry Markopolos started out looking for the secret sauce and ended up finding a Ponzi scheme!
Markopolos kept investigating Madoff and later concluded, using the baseball analogy, that Madoff would be like a baseball player hitting 0.925 straight for 10 years in a row. Few people would believe a professional baseball player could do a 0.925 every year. Why would Madoff or anyone else for that matter be any different as an investment manager?
Harry Markopolos dogged the Security Exchange Commission (SEC) for years with his warnings about Madoff. But no one listened to him. This is now a well known story. There is no excuse for the SEC to have missed all the warnings about Madoff. But that is another story for another post in my blog.
The story of Madoff is surely a serious reinforcement of this basic investment maxim given by Buffet. Back when Madoff was still the emperor of his own empire, what did Buffet think about Madoff? I am sure that Buffet, being someone who practices what he preaches, would never invest with someone like Madoff.
I am sure future Ponzi schemers will try to learn from Madoff too. For ordinary investors and fund managers alike, the following Madoff investment lessons are a good foundation to build on. Spotting a Ponzi scheme is not an exact science. But any investor ignores these lessons at his or her own peril. As many Madoff investors found out the hard way, it can be perilous and ruinous not to follow these principles.
Fund managers such as Walter Noel (Fairfield Greenwich Group), Jeffry Picower and Ezra Merkin certainly did not follow such investment principles. They just passed the bucks to Madoff without asking any questions. Why did they not bother with asking simple questions about Madoff? In my view, it is imperative even for ordinary investors to follow these basic investment advice and asking basic questions.
Some Madoff Investment Lessons:
- If it seems too good to be true, it probably is.
- Don’t put all your eggs in one basket.
- Get a second opinion. If you have millions to invest, pay an independent advisor to check out the fund manager.
- Do not rely on “collective due diligence”. Just because a fund manager has a stellar reputation in the street, it does not mean no independent verification is needed.
- If you do not understand, as a concept, the investment principle used by your prospective fund manager, do not invest in it.
- Don’t fall for the limited edition marketing ploy. You should not have to beg someone to take your money. If you have to get the papal dispensation before you can invest (as in the case with Madoff), beware. It all boils down to your goals for investing. Do you want to have the feeling of superiority that comes from joining an exclusive club or do you want to accumulate enough assets for your retirement?
- No veil of secrecy around the investment offered by the fund manager. Once again, investment is about accumulating assets and not about joining a secret fraternity. If the prospective fund manager wants you to stay mum about the investment and even its existence (as in the case with Madoff), stay away.
Any comment? Any other basic investment principles that can be helpful to ordinary investors?