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Five Lessons for Investors From the Madoff Scandal

For as long as there have been investors, there have been scams like the one allegedly perpetrated by Bernie Madoff.

The difference in this particular case is size. At $50 billion, the fraud is considered the largest in financial history, and its tentacles continue to spread from individual investors to mammoth charities and corporate leaders.

But even in such a large swindle, there are lessons for every investor. Experts offer five basic strategies for avoiding the kinds of traps that Madoff's victims fell into.

1) Understand Your Investment

The web Madoff spun took in some of the most sophisticated investors in the world, including DreamWorks CEO Jeffrey Katzenberg and famed director Steven Spielberg.

While Madoff told them he was using a fairly uncomplicated blend of stock and options buys, authorities now believe—as some analysts have previously suggested—that there existed clear discrepancies between what Madoff said he was doing and the correlating numbers in his trades.

Such obfuscation should have been a clear sign that something was wrong.

"You sometimes see situations where people invest in something based on a rate of return without really understanding all the mechanics and the substance of the underlying assets," says Bill Leone, a partner at Faegre & Benson and the former U.S. Attorney for Colorado. "I think for investors it's generally a bad idea to invest in something you don't understand."

Investors should get a full breakdown of where their money is going with any fund. But sometimes the enticement from the types of returns Madoff was generating before the scheme blew up are too irresistible.

"Twenty years ago you had sophisticated investors that were buying and selling into the market," says Julie Murphy Casserly, president of JMC Wealth Management in Chicago. "Today, that's not the case. You have people who are very uneducated investing in the markets. They don't understand how to analyze a portfolio."

But they do know how to chase returns. Which leads to the next point...

2) Don't Chase Returns

The biggest incentive to buy into an investment vehicle, of course, is that it's generating big money for its investors.

But in many instances, especially in cases like the Madoff fund, by the time big returns are getting noticed the investment has already seen its best days.

"People are chasing the number, and most of them get into them after the returns have already been had," says Casserly, who cites last year's popular emerging markets trade as an example.

She points out that $1.9 trillion went into developing economies in August 2007, just at the point that institutional investors were pulling out. In 2008, emerging markets have tanked as the global recession has spread.

In the case of the Madoff investment, the Ponzi scheme by design is set to reward those who get in the game first, who are then paid returns with money that comes from later investors.

The damage is especially egregious to those who put most or all of their savings into the funds.

3) Remember Not to Put All Your Eggs...

In one basket—or one financial adviser.

"You might trust someone, but I encourage people to get a second opinion especially in this environment" says Joan Kane, founder and director of Investment Planning Solutions in Fairfax, Va.

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Investors should never have more than 10 percent of their portfolio in one fund, Murphy says.

"There are a lot of opportunities that are in the marketplace. The question is, does that product fill what your own personal strategy is," she says. "That is what most people are missing."

Some investors lost virtually everything by trusting their own financial advisers, who in turn were dumping money into Madoff's operation.

"The red flag is if you're making money in the worst bear market in history, there's a problem unless you're short-selling," Kane says. "The average investor is smarter than that. To me I really think that these people are supposedly some pretty bright people who let greed rule over common sense."

Had common sense prevailed, some argue, there were clear signs that something was amiss.

The Final Two Tips: 'Could it Have Been Avoided?'

4) Do Your Due Diligence

There were fundamental problems with the Madoff fund, say investment professionals familiar with the case. One was the absence of basic legal disclosures on the broker's statements he provided. Another was the absence of high-profile accounting and auditing teams working on the Madoff books.

In other words, more red flags.

"I would guess there was a lot of mischief being handed to the auditors that prevented this from being exposed sooner, because no auditor regardless of size would go along with a crime of this level and this magnitude," says Jordan Kimmel, a fund manager with Magnet Investing in Randolph, N.J.

"This is one of the clearest lessons that there are top-flight auditors who do look more carefully at more items, and the use of real small-time unknown auditors on a fund this size has been sending out loud warning signals for years."

The problem in the Madoff case was that he was so well-insulated, with a five-year rate of return and numerous testimonials from high-roller clients, that it was difficult for many investors to sift through the static and find out how the fund was being managed.

Video: Restoring trust in the market

"Once you get to the point where you can show a five-year rate of return and you have high-quality references—people who have been paid and can vouch for those rates of return—then those things can grow very quickly into a large fraud," says Leone, the former US Attorney. "Then the only thing that stops them is when they get so large they collapse of their own weight or something bad happens in the economy that exposes the scheme."

Which leads to the final point: That when there isn't a sufficient level of transparency, when others vouch for a manager's character, and when returns are absolutely irresistible, it's best to keep in mind that ...

5) If It Looks Too Good to Be True ...

Then yes, it probably is.

And that may be the great lesson in the Madoff case, that even the shrewdest investors can get trapped by a pretty house of cards just waiting to get blown over.

"When people see returns that are too good to be true or extraordinarily high, they should always, invariably, without exception, their antennae should vibrate that whatever this investment vehicle is it's got to carry with it a high rate of risk," Leone says. "There's no free lunch."

For Investors

Even for those who still can't resist the temptation, Casserly's strategy of taking a small taste and seeing what happens from there provides shelter from total calamity.

"If it does fall apart you're not going to be happy but at least you were able to scratch that itch," she says. "It's like playing the lottery."

In this case, though, the losers are spread far and wide: Investors, charities, corporations and even the hedge funds themselves, which have sustained another black eye during a difficult year for the industry.

For the market, there will be many lessons to be learned, which no doubt will be dissected well into the future.

"Could it have been avoided?" Kimmel says. "Only through more due diligence, but you could even say that criminals have a way of figuring out how to go around each obstacle that gets in front of them.

"You come up with a better mousetrap, the mouse just figures a way to get around it. This was, in fact, a rat."

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