13 years ago, Bernie Madoff was arrested for running the largest Ponzi scheme in American history. He stole billions of dollars from everyday investors who trusted him. He wasn’t some nobody who slid under the radar, either. He was the chairman of the Nasdaq in 1990, 1991, and 1993, and he was earning nearly $100 million a year. His fraudulent activity instilled fear and distrust of financial professionals across the country.
Let’s talk about:
– What he did
– How he got away with it
– How he impacted investing for decades to come
– How to protect yourself from fraud
What He Did
Madoff dumped all his “clients’” (aka victims) money into one large pot. It was literally sitting in a Chase Bank account doing nothing. Rather than implementing a solid investment strategy, he pretended to have one. He told his clients they were making money. If they asked for their investment back, he gave it to them… sort of. He was actually giving them money that new clients deposited. He bragged about fake returns, attracted new clients, and paid his old clients off with the new. On and on it went for decades.
He also ran a legitimate business as a market maker, which provided cover for his illegitimate dealings.
How He Got Away With It
People were making money, so they weren’t exactly concerned. They checked their pretend statements, saw a profit, and called it a day.
He had a “window portfolio” that people could look at and say, “hmm… seems safe.” He had consistently high returns, but not too high (that might draw unwanted attention).
Bernie Madoff was respectable. He was charitable, confident, and appeared honest. However, he nearly wiped out a few charity funds he managed.
As both the advisor and the custodian, meaning he “managed” and physically held the assets, he was able to create fake client statements without anyone knowing the difference. Then the market crisis of 2008 hit. Clients started asking for their money back faster than Madoff could keep up. He confided in his sons, who promptly turned him in.
A man named Harry Markopolos suspected his illegal activity and reported it to the SEC in 2000. A whole 8 YEARS before he was caught. He wrote the SEC again in 2005 and the SEC “investigated,” yet the fraud continued. If the market crisis hadn’t occurred, who knows when Madoff would have been caught?
How Bernie Madoff Impacted Investing for Decades to Come
This was a major news story, and it is still talked about today. Madoff’s actions definitely impacted the formation of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
This act did a lot to protect consumers… but it might have been too little too late. Madoff’s longest lasting impact might be instilling distrust of financial advisors.
– Prospective clients come into my office and ask in a nervously joking voice how they can be sure we won’t run away with their money.
– I know of a financial advisor who had a client DRIVE TO THEIR OFFICE because the advisor’s phone went down, and the client was afraid they were gone with their money.
Investors are fearful for good reason. Madoff appeared trustworthy, but ultimately was a fraud who stole from innocent people. Sadly, as it has happened before, it could happen again if advisors and clients alike are not intentionally taking measures to avoid fraud.
How to Protect Yourself
1. Consider a fee-only advisor through an organization like NAPFA.
While there still might be some bad eggs here, this helps weed some out. Fee-only advisors are less likely to encourage you to buy unsuitable products, because they don’t earn commission on the holdings you in your portfolio. A good advisor will go to battle with you and protect you from “professionals” trying to take advantage of you.
2. Hire an advisor who uses an independent custodian.
For example, I’m an advisor at Hixon Zuercher Capital Management. Hixon Zuercher Capital Management does NOT hold our clients’ money. All of our clients have accounts in their name at Fidelity Investments.
If a tornado took out all our employees and our clients had no one to serve them, their money would still be safe and accessible at Fidelity.
If someone at Hixon Zuercher wanted to steal money from clients, it would be pretty dang hard. Why? Because Fidelity only allows money to be sent to client-approved accounts, when signed off by the client. And if Fidelity sees money leave accounts, they notify our clients directly.
Having third-party accountability gives the client peace of mind that their advisor can be trusted.
3. Get familiar with your investment accounts.
If your assets are scattered with a dozen different companies, you probably have a hard time monitoring them. Do you really know what is happening in your accounts? If money went missing, would you even notice? Consider consolidating your investment accounts.
Bernie Madoff died the week I wrote this blog. It might be bad karma to talk badly about the dead, but I think it might be worse karma if I didn’t use his story as an educational tool to prevent people from becoming future victims of fraud. Equip yourself with knowledge to spot bad actors before they spot you.