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5 Rules for the Fiduciary Seeking to Avoid the Next Madoff

October 01
01:28 2009

If there’s one thing we learned from the Bernie Madoff Ponzi scandal, it’s that even the “sophisticated” rich can fall victim to relatively simple and easily preventable schemes. Madoff bilked not only common investors, but some of the most affluent celebrities in America as well as many a fiduciary from some prominent employee retirement plans. Fortunately, we don’t need more regulation to prevent future Madoffs, we just need common sense (and, perhaps, a tad bit more enforcement of existing regulations). Here are five straightforward rules any investor and/or fiduciary can follow to avoid their own personal investment Waterloo:

Rule #1: If it’s too good to be true, it probably is. Madoff’s entire thesis lay on the foundation of greed – not merely his own, but the greed of those investors and financial consultants he fooled. Face it, no investment book promising merely modest returns ever became a best seller. The hoi polloi – “sophisticated” or not – constantly searches for that free lunch. The masses mistakenly believe they alone will profit from a popular fad. Unfortunately, shady gimmicks involving investments often depend on “the greater fool” theory, i.e., there’s always another sucker willing to fork over his life savings. It’s only when the conniver runs out of fools (or, in the case of Madoff, the market crashes), that the subterfuge is exposed and naïve investors realize their faux pas. It’s best to take steps to lower your vulnerability – and, in the case of the fiduciary, your fiduciary liability – to this temptation by adopting common sense procedures to protect yourself from both unscrupulous criminals (the Madoffs of the world) and unsuspecting professionals (remember, Madoff tricked high powered investment professionals, too).

Rule #2: Resist the temptation of chasing performance by regularly updating your investment goals and tying them directly to a tangible objective. Have a plan, set goals and monitor your progress annually (the typical fiduciary will create an investment policy statement for this purpose). If I’ve said it once, I’ve said it a million times, no one wants “Here lies John Doe. He beat the S&P 500.” on their tombstone. Since you can’t take it with you, it’s important to know what you need to live the life you want – to achieve your lifetime dream! Sometimes, if you plan properly through the years and you’re very fortunate, you won’t even have to worry about what the stock market does. But, if you get caught up in the cocktail party chatter of one-upmanship of investment performance, you’ll eventually find you’re merely setting yourself up as an easy mark for the next Madoff.

Rule #3: Turn aside the use of one “bundled” provider for everything by employing multiple independent service providers. Madoff apparently manipulated his books and statements to reflect imaginary returns. One-stop-shopping might make sense for big box stores selling commodity items (i.e., where quality doesn’t matter), but it certainly fails the smell test for your retirement and investment accounts. For individuals, this mean making sure your investment adviser does not hold custody of your assets and is truly independent from (i.e., not selected by) the custodian of your portfolio. This ensures you receive statements from two unaffiliated companies. To add a higher degree of safety, you might want to make sure you can trade with different brokers. For retirement plans, in addition to separate custodians and investment advisers, you’ll also need to have an independent third party administrator (a.k.a. recordkeeper) as well as an independent auditor (for plans large enough to meet this Department of Labor Requirement).

Rule #4: Family, friends and folks with impressive resumes require just as much, if not more, due diligence as anyone else. The real sad part of Madoff’s machination is that he took advantage of people close to him, many of who relied on his notable credentials. This doesn’t mean you can’t or shouldn’t use family and friends or that you should ignore a person’s past experience. It does, however, suggest an investor should select an investment adviser through a thorough and consistent process – no matter what the relationship you have with the investment adviser and no matter how spectacular the biography of the investment adviser appears.

Rule #5: You can’t depend on government regulators. Madoff was regulated by the United States Securities and Exchange Commission (SEC). They failed to discover his ruse for a number of reasons, mostly because it was difficult to independently confirm Madoff’s records (see Rule #3) and because, unlike mutual funds, there are no independent audits required for the private investment fund Madoff created. One thing we know for sure, more regulations would not have helped the SEC. Lamentably, Madoff violated existing regulations and the SEC just did not catch them. Still, if a diligent regulator can’t find a problem, how is a regular investor supposed to unearth it? Simple, just follow common sense (and Rules 1 through 4).

There you have it, the lessons of the Madoff Scandal. Whether you’re an individual investor or an ERISA/401k fiduciary, you’d be fortunate to have a supplier that doesn’t insist you obtain all financial services under one roof, one that believes clients are best served by a team of independent service providers and one that keeps you focused on your real needs, not the distracting roller coaster of the markets.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


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