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Madoff; Redux February 11, 2009

Posted by shaferfinancial in Finance.
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I commented on the Madoff fraud a couple of weeks ago with my opinion that active investors would not have been caught up in this.  I thought while we were discussing risk, it would a fine time to revisit my thoughts.  Active investors understand that nothing goes up forever.  Active investors also understand that if you are getting returns consistently over years that exceed 4% there is risk involved.  Any investment that returns 8-14% year after year with no years of downward movement defies the laws of finance.  It just doesn’t happen.  The risk in investments is the downside risk, as it can do two things.  One, and this is especially true if you are using leverage, you can go bust or lose your entire capital.  And two, people’s ability to stand firm when the value goes negative is key to getting high returns.  Now, if you are investing in real things like businesses or real estate, you can see the inherent value.  If you are investing in paper contracts or trading stocks or investing in a money manager’s ability then the value gets convoluted into price.  My opinion is that for the majority, if they are to withstand the downside, it is better to have something they can see.  If you spend the time to evaluate a business, understand what it does and how it makes money, you are more likely to weather the storm when the stock market turns negative.  

Now if you don’t do that, and the market or some “expert like Madoff” is what you are investing in, then you are more likely to get caught up in a scam or conversely sell when your investment value goes down significantly.  Investors that think any one person can manage money in a way that doesn’t have periods of lowering values simply didn’t take the time to understand risk; just like believing in the tooth fairy!

So investors in Madoff, chose to believe in the impossible; consistent positive returns of 8-14%.  Any one with even a small knowledge of the market and trading strategies understands that was impossible.  Yet, some pretty sophisticated folks, people who actually managed large amounts of money, chose to believe in the investment fairy leading them to the pot of gold!

Risk avoidance leads to poor investment decisions.  Managed risk leads to proper investment decisions.  Remember these two statements; print them out and put them on your bulletin board!

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