Rebuilding After Madoff

On Saturday, May 20th, HBO released its new film, The Wizard of Lies, which depicts the events leading up to and following the arrest of Bernie Madoff.  While it does a reasonable job explaining how Madoff ran the largest Ponzi scheme in history, its core storyline is about the type of person Madoff is and how he justified continually deceiving virtually everyone in his life.  It details the impact of his crimes on his investors, many of whom had no idea their investments were even associated with Madoff, and the impact to his immediate family.

We can quantify Madoff’s damages to some extent.  It is estimated that he lost between $50 and $65 billion dollars of investors’ money over the course of his Ponzi scheme.  Let’s dig into that number a bit.

Madoff actually received about $18 billion in client deposits, a significant portion of which came from so-called ‘feeder funds’.  These are mutual funds that had their own branding and their own managers, who essentially raised money from clients that got deposited with Madoff.  The feeder fund managers just passed the money along to Madoff to do the investing.

Once Madoff received the money, he claimed he invested it in his proprietary hedge funds.  He sent clients monthly statements showing the trades he had placed and the investments they held.  He also reported his gains on these statements.  In a given year, he reported gains from 12-18%.  Over the course of nearly 15 years, the largest one-month loss he ever reported was .55%.  Even when the market was down, he kept reporting gains.  It was this seemingly winning track record that attracted more and more clients.

In reality, Madoff never invested a dime of his clients’ money.  He took their cash, spent a lot of it, and kept some of it on hand for when investors asked for withdrawals.  The client statements, the funds, the trades and the gains were entirely fabricated.  When people say he lost $50 to $65 billion dollars, $18 billion of that was from the original client deposits.  The difference is the made-up gains he reported, which never actually existed.

When the Great Recession took hold, many of his investors began asking to take money out of the funds, fearful of what was happening in the economy.  Clients requested a total of $7 billion of withdrawals.  For a while he was able to cover withdrawals using cash deposited from other clients (the essence of a Ponzi scheme), but by the time he was down to the last $300 million he knew he could no longer keep it going and confessed the “one big lie” to his family.

Although $11 billion of the $18 billion of original investment has been recovered and returned to investors, Madoff has caused irreparable harm not only to his investors but to a generation of individuals who watched this horrific incident play out during one of the scariest financial times in our history.  It has sewn seeds of distrust that still haven’t been shaken nearly a decade later.

Today, nearly 13% fewer people own stocks than did in 2007.  Of those, it is the middle class and the Millennials that have retreated the most from the market.  The percentage of middle class Americans that are invested in the market has gone down by 22% in the past 10 years.  Only 38% of people age 18-34 are invested, compared to 52% before.  It’s tempting to chalk that up to a struggling economy and conclude that people must just have less to save, but the national savings rate has actually increased by 4% from its lows in the mid-2000’s.  Over half of Millennials are saving at least 5% of their income.  It seems they just aren’t putting it in the stock market.

The rejection of the stock market can be devastating to one’s ability to grow their assets and achieve their goals, especially for young people.  The S&P 500 Index since 2009 has returned a compound annual return of 14.5%; money lost by sitting on the sidelines.  Of course, foregone gains aren’t nearly as salient as losing money to a fraud or to a broken market.  The scars of the latter run much deeper, even to those who weren’t directly involved.

Perhaps Madoff’s losses should include the foregone gains of people that have stayed out of the market because of what he did.  Of course, it won’t be Madoff that suffers those consequences; the consequences will fall on people who are simply trying to protect themselves and don’t know a better way.  To that, I offer just a few ways to protect ourselves when we decide to enter the market:

  • Work with an advisor that is registered with the SEC or with their state.
  • Look up your advisor on Broker Check to search for disciplinary actions taken by regulators.
  • Use independent advisors and custodians, for example use TAAG as your advisor and Schwab or Fidelity is your custodian. This means you get statements from multiple parties so you can verify that what is on the statement is accurate.
  • Own publicly-traded securities so you can look up holdings, prices and fees anytime.
  • Accept that down markets are part of investing and that if someone is reporting unwavering gains, it’s likely a sign of fraud.
  • Learn more at the Securities and Exchange Commission website.

It’s important that we share these lessons with people who won’t seek advice from people in the financial industry.  Rebuilding trust is difficult, but so is rebuilding wealth without the help of stocks.

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