I don’t blame the Madoff investors for investing in his hedge fund. Truth is, we all make some mistakes when investing. But, like Ben Franklin used to say; “Experience keeps a dear school, but fools learn in no other.” It makes sense to take a critical look at the way Madoff set up his scheme, then figure out how to avoid the mistakes his investors made.

Why Madoff had such a successful scheme

First and foremost, Madoff had a lot of credibility. He created an over-the-counter trading firm in the 1970s and was the chairman of the NASDAQ stock exchange. Later, he started the (Ponzi scheme) hedge fund. It’s very reasonable to assume that someone who can run NASDAQ can run a hedge fund.

Madoff was savvy about finding investors. Madoff used a time-tested strategy known as an “affiliation scam.” In an affiliation scam, you get members of a group to introduce you to friends and family. You gain the victims’ trust through the affiliation. If your friend trusted Madoff, you were more
likely to trust him, too. This approach worked because it’s a common way that people find legitimate investment advice.

With all this in mind, I really felt for the victim on 60 Minutes who had lost everything. He was moving out of his house during the interview. He said what was worse than losing his own money was that he had introduced a bunch of his friends to Madoff, and they lost their money, too. Madoff
recklessly used this man.

Madoff was a genius at hiding what he was doing. Most people bought into Madoff through “feeder-funds,” which are mutual funds that pool together other mutual funds and sell them as a “Fund of funds.” These investments in Madoff’s hedge fund were sold to individual investors by commissioned investment
advisors. According to Stephen Greenspan, a Madoff investor who ironically wrote Annals of Gullibility, he bought the “‘Rye Prime Bond Fund’ that was part of the respected Tremont family of funds, which is itself a subsidiary of insurance giant Mass Mutual Life. ” A trusted advisor sold Greenspan the fund. All this reduced the chance that any investors prudent enough to read the prospectus would actually pick up on any problems.

So Madoff had a good set-up for his scam. With the benefit of hindsight, there are a bunch of lessons to learn on how to avoid these scams.

Lesson One: If you don’t understand it, don’t invest in it.

Investors in Madoff say they did not understand his investment strategy. Reporting going back to 2001 in Barons tries to figure out how he produced his returns without success. Madoff fired clients who asked too many questions and claimed his strategy was a proprietary secret.

If, after your financial advisor explains how you’re investing and what you’re investing in, you can’t explain it to your spouse or friend, think twice. That doesn’t mean you have to regurgitate the strategy word for word months later. A lot of folks don’t commit their financial strategy to long-term memory. You should, however, understand your strategy and the investments you are buying well enough to explain it at the time you are investing. Peter Lynch used to recommend writing a paragraph about why you are buying a particular investment, which is a pithy way to test your understanding.

Lesson Two: Use your friends wisely.

When talking to friends about advisor’s and investments, ask, “Do you understand your investments?” If your friend says, “My advisor just does it all for me,” realize that your friend is assuming a tremendous amount of risk. Everyone makes investing mistakes and trusts the wrong people sometimes; blind faith increases your chances.

Ask friends who are not affiliated with your usual circle if they understand the investing strategy. Stephan Greenspan, the gullibility expert who was scammed, told a friend about the potential Rye Prime Bond Fund investment. The friend, just hearing the details, thought it was a scam. Don’t ignore neigh-saying friends.

Lesson Three: Don’t expect consistent high returns with no down years.

Reports vary as to what returns Madoff promised. Some say up to 46% returns. According to Stephan Greenspan, Madoff offered 10-12% returns without bad years. Don’t expect 46% in good years. Unless you are investing in US Treasuries and CDs, don’t expect to avoid down years.

Lesson Four: Diversify your assets.

Unfortunately this piece of advice from Investing 101 wasn’t followed by all of the investors in Madoff. When I hear about the investors who lost everything, I think, what a shame! Didn’t they hear about investors losing everything in Enron and diversify? What happened here?

Lesson Five: Keep documentation when you purchase investments.

According to the Wall Street Journal, victims of the scam are frustrated because SIPC, the regulatory body that insures brokerage accounts, wants purchase documentation to prove investment losses. In some cases, the initial investments go back to the 1970s. The lesson is: sales information is easy to find; keep purchase information.

Lesson Six: Doing everything right is no guarantee.

However, trying to do things right is the only approach we’ve got.