Avoid the Next Madoff Scam

The only thing worse than investing in the stock market last year was investing with Bernard Madoff, whose alleged Ponzi scheme is said to have cost investors as much as $50 billion.

Many of the people who lost money because of Madoff should have known better. His victims included big banks and even Henry Kaufman, a well-known Wall Street economist. Many advisory firms that were in the business of vetting hedge funds before recommending them to clients failed to warn their customers away from Madoff. Even Stephen Greenspan, an emeritus psychology professor who just published a book titled -- no kidding -- Annals of Gullibility: Why We Get Duped and How to Avoid It, fell for the scam.

Why did so many sophisticated investors turn out to be so gullible? What can you do to avoid their fate?

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Investors were fooled because Madoff had a sterling reputation, and he and his marketers had personal relationships with many of the victims. You tend to trust experts you know well and who've given you good advice in the past.

Shrewd investors would have smelled a rat had Madoff promised enormous returns. So he offered relatively modest returns, about 1% monthly. Surprisingly, psychological studies have found that investors almost always choose small, consistent returns over big -- but uncertain -- payoffs.

I considered Madoff perhaps the savviest market maker on Wall Street. He set up electronic systems that matched buyers and sellers, often providing them better prices and faster executions on stock trades than the New York Stock Exchange did. At one point, he was chairman of Nasdaq.

Madoff was widely admired and seemed to have boatloads of money. He had no apparent reason to steal a dime, solidifying investors' trust in him. And yet steal he did. His motive remains a mystery.

Keep it simple

How can you protect yourself against his ilk? Investors who keep things simple could never be scammed the way Madoff's prey were.

From my experience, investors often court trouble when they get fancy. You can make money dabbling in options, shorting stocks, buying complex securities and trading frequently. But most of the time, you don't.

Incredibly complex securities based on subprime mortgages triggered much of the current financial crisis. But mortgage derivatives are hardly new; 15 years ago, they were responsible for the implosion of Piper Jaffray Institutional Government Income fund. Manager Worth Bruntjen beat funds that invested in ordinary mortgages, such as Ginnie Maes, for several years, but his fund plunged 30% in 1994. Piper was fined more than $1 million, and the firm paid $67.5 million to settle investor lawsuits.

Madoff said he employed a "split-strike conversion" options strategy. Judging by his marketing materials, it appears that he employed little more than a fairly simple "collar" strategy. With a collar, an investor buys a stock, then sells call options and uses the proceeds from the sale to buy put options (see Hedge Your Bets to learn more). If the stock's price drops, the investor's loss is limited by ownership of the puts, but if the price rises, the gain is limited by sale of the calls. Well-executed collar strategies can make you money, but they are no way to get rich. Of course, who knows how much, if any, of the money he collected Madoff ultimately invested.

Remember, many of the financial advisers Madoff fooled are paid primarily to separate the wheat from the chaff among hedge funds. I wonder how well they understood split-strike conversions.

Many people believe there are investors -- the so-called smart money -- who know the secret to beating the market. I don't think any such geniuses exist. No one has a crystal ball. Thanks to current technology, detailed information about companies and markets reaches investors almost instantaneously. That makes it increasingly difficult to beat the market.

I think there are managers who -- by dint of a passion for what they do, a disciplined approach, enough smarts and lots of hard work -- can beat the market. But not by a lot, and certainly not all the time. That's why I don't think you should ever pay sky-high prices for a mutual fund or an investment adviser.

You'll likely do best by sticking to common stocks, plain-vanilla bonds and low-cost mutual funds. If you're looking for excitement, maybe you need a hobby.

In particular, you should stay away from hedge funds. By definition, these investment pools are barely regulated by the government. On top of that, they charge obscenely high fees. Typically, hedge funds charge investors 2% of assets annually plus 20% of profits.

Some hedge funds simply invest in stocks and bonds, but most use esoteric strategies. You can find equally talented managers running mutual funds at a tiny fraction of the cost -- and get regulation thrown in for free. Of course, the Securities and Exchange Commission failed to detect fraud in Madoff's operations following repeated allegations that he was running a Ponzi scheme. But I'd still rather invest with a manager who is monitored by the government.

One last piece of advice: If you hire an adviser or other professional, make sure that you don't sign over a check directly to him or her. Instead, open an account with a reputable brokerage firm, such as Fidelity, Charles Schwab or TD Ameritrade. That allows your adviser to buy and sell securities for you but prevents him or her from emptying your account and heading for Tahiti.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.