The Madoff Antidote

Time to get back to the basics of investing. Plus here are some high-yielding, financially solid companies to consider for your own common-sense portfolio.

By James K. Glassman, Contributing Editor

From Kiplinger's Personal Finance magazine, April 2009

Bernard Madoff, the once-admired financier and former chairman of the Nasdaq Stock Market, left a great deal of human misery in his wake. Madoff is said to have admitted to running a Ponzi scheme that cost investors some $50 billion. Rather than making profitable investments, a Ponzi operator satisfies current investors by paying them with money from new investors -- until the edifice collapses under its own weight.

Madoff, it seems, was particularly adept at this game. But Madoff's nefarious activities also serve a beneficial purpose. He inadvertently provided important lessons -- not just for avoiding Ponzi schemes but also for investing in general. Here are six:

1. Diversify.

On a recent visit to Palm Beach, Fla., epicenter of the Madoff nuclear explosion, I heard stories of widows putting every dollar of their financial assets into his investments. According to the New York Times, the Elie Wiesel Foundation for Humanity lost almost all of its assets because of Madoff. The Carl and Ruth Shapiro Family Foundation lost $145 million, and Carl Shapiro himself, more than a half-billion. Richard Spring, 74, who had known Madoff since the 1970s, placed his entire $11 million with the financier.

As employees of Enron learned in 2001, the value of an individual investment can sometimes go to zero. The only sure way to cushion such an event is to avoid putting all your eggs in one basket. This is a lesson that history has taught over and over -- to little effect.

2. Watch out if it looks too good to be true.

As the Better Business Bureau puts it: "If it sounds too good to be true, chances are it's a scam." What Madoff promised were high returns with low risk and abundant liquidity. He was saying, in effect, "Invest with me, and I will provide you with returns of about 10% every year. If you need your money back, I will give it to you in a few days." (Even in 2008, with the broad market down nearly 40% through November, a Madoff hedge fund had supposedly gained 6%.)

Such investments simply do not exist. Yes, the U.S. stock market has returned an average of about 10% a year over more than eight decades -- but with high annual volatility. In investing, you trade high returns for low risk; you can't have both at once. What Madoff was offering was essentially a highly liquid bond. If a two-year U.S. Treasury note was yielding 4%, and Madoff was practically guaranteeing a return six points higher, then alarm bells should have been ringing.

3. Know your investments.

Based on the reactions of those who lost millions, I would guess that most of Madoff's investors had not the slightest idea what they were buying. That's dangerous. At the least, it means that you can't balance your portfolio among different assets because you don't know what the assets are. In Madoff's case, it meant that he may not have been investing your money at all.

Madoff said he was using a "split-strike conversion" trading strategy. The objective is to put a "collar" around an investment, which limits losses but also caps gains. The strategy involves buying a basket of blue-chip stocks, selling out-of-the-money call options on an index of which the stocks are a part, and buying out-of-the-money puts on the index for protection on the downside (see Hedge Your Bets).

Other money managers use variations of this strategy. One of them, Harry Markopolos, filed several complaints against Madoff with the Securities and Exchange Commission. Markopolos contended that Madoff's version "should not be able to beat the return on U.S. Treasury bills" -- far less than the range of returns, between 6% and 20% annually, that the system is supposed to have achieved.

Markopolos's 2005 complaint against Madoff makes fascinating reading. But just use your own common sense. If such a system really could produce such huge returns, wouldn't other money managers have adopted it and, by so doing, reduced its effectiveness? And why, as Markopolos asks, would Madoff be willing to share his profits by inviting other investors to participate and simply skimming off fees? If you had discovered investing's Holy Grail, wouldn't you keep it to yourself?

Read your monthly or quarterly statements. Understand what investments you own and what risks you're taking. You certainly can't be expected to follow every trade a mutual fund manager makes, but you can be expected to know that you're in a small-company stock fund or a corporate bond fund.

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