The scam was written all over the wall yet no one saw it coming
The $65 billion MADOFF scam happened not only because regulators failed but also because investors forgot investment basics: greed overcame rationality, and when greed overcomes rationality, people like Madoff prey upon investors’ greed.
Bernie Madoff, born in 1931, had a long connection with the financial world. He first opened his trading office in the 1960s; the office mostly dealt with unlisted stocks. As he became successful and his success drove him to the centre of the financial world, he became known as an astute investor.
Why did the scam continue for over a decade?
He introduced computers at his office when other offices used pen and paper. Further, he helped establish the NASDAQ stock exchange and sat on the board that advised the National stock market. He was an insider of the financial world, and his reputation preceded him.
He was close to regulators, and he knew what regulators were doing. Even when an informal complaint came up with the regulators about Madoff, the regulators didn’t think or didn’t want to think that someone like Sandoff ran a scam.
Further, the turf war relating to investigation jurisdiction among regulators was also one of the reasons why the scam continued for so long.
Madoff’s investing strategy was he had no investing strategy
Madoff’s scam was simple: “Trust me, and I will screw you sooner or later.” He presented his scheme in financial jargon, suggesting that he was investing in the market, but he never invested a single penny in the market. That’s why jargon should be avoided, whether in writing or in a financial scheme.
Madoff’s scheme was the Ponzi scheme or the pyramid scheme. The scheme can be summarised as “Rob Peter to pay Paul.” As long as he could find new investors, the oldies could get their promised returns on their investment.
People who joined the scheme early — the oldies — had a better chance to recoup their investment than those who joined later. Once the new investors stopped coming, the returns also dried. That’s how a pyramid scheme works.
Most of his funds were feeder funds: investment managers invested in Madoff fund without due diligence. Madoff’s scheme promised an unusually high return even when the markets were down, considering he said that he invested the funds in the market.
How can a market-driven fund deliver a high return even when the market is down? That was a red flag, but Sandoff was a man of his word: he kept paying the returns on time to the investors. That’s how people stay in Ponzi schemes; the returns are their incentive to stay.
But the 2008 crisis became the undoing of Madoff’s scheme: $12 billion were withdrawn by investors from Madoff’s funds within a short period. He still had to pay $7 billion but only had $200–300 million in his account. He didn’t stand a chance to save his scheme.
Lessons from the Madoff scam
Don’t put all your investment in one basket.
Understand the scheme; understand where your money is going; if the scheme is filled with jargon and you are clueless about where your money is going; STAY AWAY
Understand that scheme that invests in the market will give you returns at a market rate.
If the promised returns are high, 9 out of 10 times, it’s a red flag
Don’t invest money because someone has referred the scheme or the reputation is all you know. Verify the scheme details yourself.
Never invest the amount which takes care of your day-to-day expenses; invest the extras if you have.