'til the Music Stops

Warren Ward |
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Fortune magazine recently published an excerpt from a new Bernie Madoff book. As I read once again about regulators’ half-hearted attempts to investigate someone they considered to be above suspicion, I wondered how many similar books will be written and, perhaps more importantly, how many of them will actually be read.

 

A check with Viewpoint, our local bookstore, shows that about 20 Madoff titles have already been published. While there’s really no way to answer my second question, I think it’s important that the investing public becomes familiar with these too good to be true deals. There are dozens of examples to choose from, with Madoff’s simply being the largest in recent history. Don’t forget Allen Stanford and his Antigua bank-issued CDs and Indianapolis-based Tim Durham’s systematic looting of Fair Finance. I suspect there have probably been cons nearly as long as there’s been money and, regardless of what’s promised, they exist only to generate money for their perpetrators.

 

Do participants ever have second thoughts after investing in one of these deals? Unfortunately, only rarely. One reason is what is known as confirmation bias, the tendency to look for data supportive of a decision already made or belief already held. Just as someone who is a regular church attendee might be likely to see a divine hand in a positive outcome, someone who has made an investment is likely to look for data which validates that it’s a good one. In the words of historian and author Michael Shermer: “Smart people believe weird things because they are skilled at defending beliefs they arrived at for non-smart reasons”. Few of us like to admit mistakes, so this effect can be seen in numerous situations but it is especially pervasive in the investment world. Unfortunately this includes the multiple regulators who failed to catch Madoff at his game, apparently having already decided he was innocent.

 

A second reason people are unlikely to change their minds is that they enjoy, perhaps even become dependent upon, the above average returns which are typical of the initial phase of these deals. This second explanation reminds me of the game musical chairs. It’s great while it lasts but someone is certain to be left standing when the music stops.

 

If you encounter a deal that sounds too good to be true, what should you do? One thought is to solicit a second opinion from your attorney or planner. During the tech stock bubble of 1998 & ‘99, Warren Ward Associates systematically reduced our clients’ exposure to small cap growth stocks as the category continued to outperform the general market. As you might imagine, there was some push-back as we made the adjustments away from that year’s hottest performers. However, our clients were quite relieved to find themselves doing better (i.e., losing less) during the subsequent market correction.

 

For Ponzi schemes such as Madoff’s to work, early investors must make unusually good returns. Although completely legal, initial public offerings bear some similarities to these schemes and IPOs played a significant role in that late 90’s tech stock bubble. Quite a few new stock issues ran up in value on their first day of trading, a fact well-documented in the media. This had the unfortunate effect of making quick gains look easy, which enticed small investors to try to participate. What apparently was not nearly so well publicized was the reality that there were multiple losers for each winner, a topic to which I’ll return in my next article.

 

Because it’s simply not possible to predict the future with any degree of accuracy, we believe a disciplined approach to investing is best for the long term. That occasionally leaves our clients with smaller positions in the very hottest sectors of the market, instead owning securities which may be temporarily out of favor. We sometimes think of this as a “get rich slow” strategy but it is one we have seen work with reasonable success over complete market cycles.

 

As I finish, let me return for a moment to the rush to publish Madoff books, since there may be a musical chairs aspect to that as well. As long as these books are selling, authors and publishers will be rewarded for continuing to bring them to market. However, it’s only a matter of time until public interest fades. At that point, new books on the topic will no longer sell – quite likely leaving one or more authors standing.