Wednesday, July 8, 2009

Investing Lessons from the Madoff Fraud - Alpha

The Madoff fraud had many red flags, as reported to the blind SEC by a do-gooder citizen in 2005, but its lessons are broader.

-Do Your Own Work: In investing, always do your own due diligence, especially if you entrust your money to someone else. Don't rely on reputation or the referrals of others, no matter how sophisticated or disinterested the referring parties are. If you don't get transparency, avoid investing. You are the most vulnerable, psychologically speaking, when someone of a similar background to you (professional or educational background, wealth/social status, ethnic background) makes an unfounded recommendation. Especially don't rely on a government agency to do the diligence for you - often the regulators lock the barn door after the horses are long gone.

-Eggs in Many Baskets: Don't keep all your monies in one place, even if the place is a "gold standard" firm like Fidelity, Vanguard, Berkshire Hathaway, Renaissance's Medallion Fund, etc. Keep the bulk of your money in at least 2 or 3 firms/accounts and in multiple asset classes (the Talmud "recommends" stocks, bonds, real estate, and cash).

-Apply Common Sense/Street Smarts: If it sounds too good to be true, like the eerily positive and consistent returns Madoff reported, it probably is. Use your common sense and exit.

-Check the service professionals: are the auditors, custodians, lawyers, etc. large, independent, and reputable outfits? If your cash/asset balance is especially large (tens or hundreds of millions or more), don't even trust the investment firm's auditor. Go straight to firm's bank or custodian, speak to an executive, and look at their statements. Read the bank/custodian's financial statements and talk to its auditors. Make sure your portion of the bank's equity cushion is small, as the audit firm's insurance may not be able to pay you to recompensate you for fraud.

-Know Your Risk Appetite: As you get closer to retirement, keep your "living expense" assets in cash, US government inflation linked bonds, or German bund linkers (basically a mix of "risk-free" assets). Take risks only with assets you plan to donate or give away. Consider this thought-experiment: if you lost *all* your risky assets tomorrow, would your risk-free assets get you by for the rest of your life?

-Be Paranoid with Redundancy/Backups:
Keep retirement cash in multiple banks in multiple "safe" countries, and consider keeping a safe store nearby in a safe house or as precious items (gold coins, silverware, portable antiquities, etc.).

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