Just when you thought it couldn’t get any worse it does. Not only is the stock market headed to end the year with one of the worst losses in recent history but now we get the news that hundreds of investors have fallen for one of the largest Ponzi schemes in history and stand to lose everything. These investors were, by and large, sophisticated and not the sort you’d expect to see caught up in a scandal of this sort. Further, the alleged mastermind, Bernie Madoff, was widely respected and had been involved in the investment business for decades. How could this have happened? Setting aside the issues of sloppy regulating, these investors made some basic mistakes and ignored red flags that could have helped save them from being sucked into this tragic scheme. Here’s some advice to help you avoid making the same mistakes.

1. Don’t be afraid to ask questions. Any legitimate investment advisor should be willing to sit down with you and explain, in detail, how they invest for returns, where your money is held and what kind of risks they take. If they’re not willing to do that then walk away, plain and simple.

2. Don’t be intimidated with talk of fancy investment strategies. Let’s face it, 90% of investing is not like rocket science, it just takes hard work. You should be able to understand what your advisor is doing and how your account is invested. If you can’t understand the strategy and how it’s executed then you’re probably better off not playing the game.

3. Avoid investing in something or with someone just because a friend does. You can not assume your friend has done all the appropriate due diligence or even understands the risks he/she is taking. Any investment or advisor you consider should be investigated completely by you and not taken on face value just because your friends are involved.

4. Trust but verify. The biggest mistake Madoff’s investors made was allowing him to hold the investments in his accounts and accepting his periodic account statements on face value. Unless you are investing in a highly regulated investment like a mutual fund or unit trust, insist that your funds be held at a third party clearing agent like Pershing, Fidelity or Schwab. Receiving statements directly from the third party and matching them against the advisor’s statements is pretty good evidence that the investments your advisor says are in your account are in fact there. A larcenous advisor can easily dummy up his firm’s statements but will not be able to falsify the statements mailed directly to you from a Fidelity or Schwab.

5. If it sounds too good to be true it probably is. As we are all keenly aware markets go up and down. The simple fact is so should your investment accounts unless they are held almost entirely in cash. Madoff posted consistently high returns in all markets, good and bad, and basically never showed a loss which made him an outlier in the investing world. It was this too good to be true performance, more than anything else that caused the few "smart" investors to see through his scheme. Accept the fact that just as there is no Santa Claus, there is no investment manager that gets it right every time, all the time.

Madoff’s investors failed to observe these basic rules or even worse, wanted to believe so badly that they ignored the truth that was right under their noses. With a little common sense, some simple due diligence, and a willingness to walk away from something that seems a bit too good to be true, you can avoid making the same mistake.

Randy Gridley

December, 2008