As you read stories about victims of the Madoff fraud, aren't you glad that you weren't one of them? Why are you so sure that it will never happen to you? How do you know its not happening to you now?
In academic financial research, there's a concept called "agency risk." Agency risk occurs when someone who is acting as your agent has a set of interests that conflict with yours. In investing, agency risk is rampant because one party can often gain from an action that will cause a loss to the investor without the investor even knowing it! Bernie Madoff was an agent of the investors who hired him to manage their money and he was crooked for years until his scheme ended. But investors face plenty of legal, yet sometimes equally dangerous forms of agency risk. It is important to understand them and find ways to mitigate these risks.
Now you have money to invest and you are about to put it in businesses that you don't understand as well, run by strangers. How your investments perform may determine the kind of lifestyle that you will lead in the future, the kinds of colleges your kids or grandkids will be able to attend or even your approach to philanthropy. So it's important to look for companies and people you believe you can trust. These are now going to be your "agents."
Suppose you buy a stock that you think will make you money. You read about it, saw the CEO on CNBC, or a friend who owns it was extolling its virtues. The success of your investment will partly depend on decisions made by management and directors. As your agent, management controls what happens to your money and they might want to pay for things that you as an owner would not.
Let's say that you bought shares in a hypothetical company called "Diversified Widgets," where the CEO was able to populate the board with directors who are all ex-frat buddies. You read an obscure paragraph in a proxy statement that the directors voted to give the CEO a large stock options package that dilutes your investment and pay him an outsized salary, taking earnings away from you. While the SEC tries to police these "unfriendly" shareholder practices, it's not that easy to detect. In the extreme case of Enron, the management team stole the whole company from its owners who lost 100% of their money.
This is why Warren Buffett prefers to purchase entire businesses, like Sees Candy, rather than own pieces of businesses by owning publicly traded stocks. He likes to be in control and not hand it over to agents called "directors" and "management."
If you buy your own individual stocks, your agency risk is a function of how much diversification is in your portfolio. But if you buy a mutual fund, you're now adding another layer of agents because you've invested in another business (a mutual fund) that is in the business of buying parts of other businesses (public stocks). The mutual fund manager is motivated to acquire more assets because he is paid a percentage on all assets he manages. In order to acquire more assets, he will do many things that are not in your best interest, including trading stocks (which creates taxes and fees), charge you fees to market to new investors, and engage in a variety of other practices that have been widely criticized in the many publications (Google "mutual fund fraud").
If you get help from an investment adviser, you're adding yet a third layer of agency risk. When you walk into your local broker, like Merrill Lynch, and ask for advice, they'll set you up with a well-groomed, smart, and articulate financial adviser who will take your money and invest it with the best mutual funds for a yearly asset management fee. You've turned into an annuity for Merrill Lynch and added a third layer of agency risk.
With three layers of agents -- all with potential conflicts -- between you and your money, what is the likelihood that you have a Bernie Madoff in your portfolio? It may be one stock with a fraudulent management team that goes to $0. Or a mutual fund that "blows up" and you lose 67% of your investment, or the supposedly safe Schwab Hi Yield Money Market Fund. Or worse yet, the broker who has not served you well and puts a serious dent in your net worth by making poor decisions on your behalf.
The point is that the more agents you have between you and your money, the higher the chances are of having fraud, underperformance, and for sure, high fees. And because agents in the investment business generally have interests that conflict with yours, you are exponentially adding to the risk that something bad can happen.
I am not suggesting that you sell your securities, buy an apartment building, fix toilets and "be one" with your investments. But here are some ways to mitigate the risks:
1. Buy ETFs. When you buy exchange-traded funds (ETFs), you are essentially paying fees for a computer to buy all the stocks in a given universe of stocks -- instead of a mutual fund manager. The costs are about 80% less and you'll also end up with hundreds of stocks instead of a handful of the mutual fund manager's favorites, which reduces your exposure to any one company and the risk that a money manager has conflicting interests with yours.
2. Do it yourself. Instead of hiring an investment adviser to manage your money, do your own investing. There are many books and software tools to help folks who aren't that interested in investing, but want to have the control. These tools are getting better all of the time. Alternatively, if you want help, pay by the hour, not a percentage of your assets.
3. Monitor agency risk. Carefully evaluate your investments, think about who is controlling your money, and the different layers of agents between you and your money. The more layers, the more people getting paid and more risk to your portfolio and investment success.
Is there is a Bernie Madoff in your portfolio? Take some preventative measures just in case!
Mitch Tuchman founded MarketRiders, an investment website providing individuals with software that enables them to invest like the world's wealthiest families and endowments.
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Reader Comments (Page 1 of 1)
7-06-2009 @ 3:12PM
thedude said...
BRAVO ! I was expecting another whinging foment by someone getting ripped off. Too many bloggers posit questions and rarely offer solutions. Although your solutions are just barely scratching the surface of what people can do.
I think you should expand on this topic and develop a series of How To Invest For Yourself articles.
When I was first getting involved with investing I looked around for an adisor/broker anyone who would only base their pay on a percentage of the profits they earned me. You kow what ? I didn't find a single willing participant.
When your money is being managed by someoen who gets paid based on fees the generate by employing methods that are often unusual and creative, you know you are being screwed.
A few tips for those unable to handle their own finances:
Don't ever trust a money "manager"
Don't ever let a money manager put more than 15% of your investment capital into a single fund
Don't even use just one money manager - split it up between a few firms and pay attention to what they are doing with it
Don't hesitate to say no to their advice
Don't hesitate to take your money away from them
Don't trust anything they say about taxes
DO - hire an accountant yearly to investigate what your manager might have you involved with
Although the best thing you can do is to take control over your own assets and educate yourself. It is your money and the only person who cares about it is YOU. Unless you're a degenerate gambler you will probably do okay. I cetainly have.
7-07-2009 @ 6:38PM
LARRY said...
THERE IS A MADOFF IN MY PORTFOLIO -- IT IS OBAMA AND HIS GANG OF THIEVES AND TAX CHEATS---------
7-06-2009 @ 6:28PM
janc said...
Yes, there is a Madoff in our portfolio and they are called Democrats who want to spread it around. It would be nice to see many of them in the same place as good old Bernie where they belong.
7-06-2009 @ 6:25PM
Richard said...
Larry you are right....overall...But I wanted to pin point another.The biggest scam of all time....dwafing Bernie's Scam...CAP & TRADE...coming soon.
7-06-2009 @ 6:32PM
janc said...
Richard, we can thank Al Gore for that one.
7-06-2009 @ 6:45PM
Richard said...
Article has good advice....Here is why I like Sara Palin...Ignore or read
. Finally, a voice of bold new fresh air for the Republican Party, other than what has been only Republican sound bites. First, might as well get the hate filled New World Order Zealots , bloggers and other sites that surely will be filling the airwaves and printed media....all touting reasons why Sara Palin should not aspire or fit for a higher political office. The rumblings have already started.... sooner than a snow flake can disappear on the 4th of July...(or sooner for all you Climate change folk)
She does not need a telepromter ...for almost every word...just a few reminders. She does not need the eloquent and chosen words, trained in university debate settings, skilled political operatives, and schooled in the back rooms and boardrooms and the streets of Chicago Style Politicians and finally, she does not have the type speech we have all heard so often, so many times, as most politicians use....for more often than not, mean many things that we the Public have been so accustomed hearing... She speaks common language. Somehow, even if you disagree with her, that in and of itself is very refreshing.
Yes, we need a voice. We are tired of the Nancy Pelosi's, The Harry Reid's, The Barney Franks, and perhapse to come, the comedian Al Franken..We are tired of all the bailouts and takeovers, and stimulus packages, We are tired of the Czars that only answer to the President and in some situations may have limited knowledge for what they have been asked to 'Czar over. We are tired and frightened and worried about all these 'Crisis' situations and the push ...so fast on issues that need more time to do right, rather then ramming through of new program after new program ..some not even read that are adding up to many more Trillions of dollars in debt with money we do not have "We are broke"..per Barack Obama. We all want some changes...We want good medical care for all...we want clean air for all....We Want Choices...not zelots with questionable motives. We are tired of all the Pork, regardless of what Democrat from NY Charles 'Chucky' Schumer stated on the Senate Floor " The People Do Not Care what Little Pork is In The Stimulus Bill"...Really? We are tired of being labeled obstructionists, bigots or racists if we disagree, We are tired with all these staged Town Hall meetings...and your one sided positions.
We are tired of this Secular America that only thinks of self first and has lost the spirit and values which has made America the ideal of people around the world.
Yes we are tired of all the scandals, the crooks and want them dealt with. We are tired of the Acorns, The Unions, and other special interests. Scared of The massive government build up the largest in our nations history that will control all aspects of our lives as well as Tax us into slaves to and for the State.
Welcome Sara Palin. You are indeed a breath of fresh air, and common sense and hope for many. You may not be the First Women President, but you might bring on that spark that starts a transition ..... in Giving Us Our Freedom and Our Country Back To Greatness.
Let us bring back these words from JFK: "Ask Not What Your Country Can Do For You....Ask What You Can Do For Your Country"
7-06-2009 @ 7:37PM
MaryLou Michelin said...
Wachovia Securities stole from me and cheated me- liars and thieves
7-06-2009 @ 9:32PM
NESWINPRINT said...
If you bought from the Arcade Currency Palace owner Ahmet Sandikci in West Palm Beach or Tarpon Springs Florida you have a major madoff in your porfolio...just go to www.keycurrency.com and click on the bad grade link and see for yourself.....
7-06-2009 @ 11:43PM
Miz von der Wouton said...
Madam Pelosi may be the next Madoff for the US via the cap and trade. Seems she owns energy stocks and stands to make some big bucks when the bill passes.....
7-07-2009 @ 3:02AM
h66mars said...
I don't know why everyone, even those not involved, have this hatred for him. He did fleece people, yes, but these people invested in the ponzie scheme because they were hoping to get big returns on thier money, and were "mislead" about the risk.
Has anyone ever seen those infomercials offering "real people" with "true stories" of making fortunes by buying some book for $29.99? Or, guarenteeing amazing new hair growth from a shompoo, losing wight w/o exercise or diet, ect.? How come that kind of scamming is allowed? Of course, these mostly affect poorer less sophisticated people, and Madoff ripped off people who had hundreds of thousands of $$$ to invest in the first place.
Plenty of people lost thier 401Ks, IRAs and pensions in the last year in the "legitimate" ponzie scheme called Wall Street. They aren't getting thier money back, and neither will his "victims" because there is no money to give back.
7-07-2009 @ 6:56AM
jo said...
Thedude You are 100% right but left out one Liar cheat and do NOTHING who lost me a LOT of MONEY because he does nothing and knows NOTHING and cares for NOONE B DUMSTAN Prime Capital Services INC. Poughkeepsie New York HE WILL PROMISE YOU THE WORLD AND YOU GET NOTHING!! THANKYOU
7-07-2009 @ 7:09AM
junior said...
I DON'T TRUST NOBODY FROM WALL STREET.
7-07-2009 @ 9:49AM
george said...
And what of the news about the SEC blocking a probe into Madoff in 2004?
And about the "Compliance Lawyer" for the Madoff racket,
Ruth Madoff's (niece) marriage to Eric Swanson of the SEC??
And of Eric Swanson's position in the SEC which may have enabled him to block any probing into the Madoff Co., particularly by his underling, Ms. Lightfoot, who might have exposed this conspiracy 5 years ago? the media made the decision that the Michale Jackson saga is of greater importance I guess.