When Investing There Is Only One Free Lunch

HARRY MARKOPOLOS is the man who repeatedly tried to draw attention to the fact that Bernie Madoff's investment fund was a huge Ponzi scheme. OK, not as huge as our Basic State Pension system, nor the largely unfunded public sector final salary promises we have in the UK, but - at US$65 billion, still pretty impressive.

His book 'No One Would Listen' is a racy account of how, from 1999 onwards, Markopolos tried to warn the American regulators that the returns Madoff said he was producing for investors were mathematically impossible. The Securities & Exchanges Commission (SEC) was almost perfectly incompetent during this time; repeatedly Markopolos would present them with in-depth reports highlighting the fraud that was Madoff. Repeatedly the SEC did nothing.

Perhaps the SEC were blind to Madoff because they couldn't understand the size of the deception. Madoff, who helped found NASDAQ, was a major player on Wall Street. He had some of the world's smartest, most prestigious investors literally queueing up to give him money. How could he be a fraud?

Sadly, like the SEC, these investors were blind to the fact that there is no such thing as a free lunch in investing. If Madoff was producing consistent annualised returns of 12% year in year out, this could only be achieved by investments that bore a commensurate level of risk, together with an alien-like ability to market time successfully, time after time (it can't be done, by the way).

Whether through greed or wilful ignorance, these investors were hypnotised by the returns on offer, drawn to the rocks by the siren call of fabulous returns, little risk and a very clever affinity scheme cache (most of Madoff's American investors were, like him, wealthy & Jewish. They simply refused to contemplate that one of their own would do anything other than look after them).

Are there other Madoff-type scams out there? You bet. In coming decades will people forget that risk and return are related, helping to fund the next Ponzi scam? Absolutely.

When markets are soaring up these scams can work, for a while, robbing Peter to pay Paul. When markets suffer (remember 2007 - 2009 folks?) the tide recedes and, to paraphrase Warren Buffet, we get to see who has been swimming naked.

Bernie Madoff swam naked for the best part of 20 years. His wealthy investors are now a lot less wealthy. So the bottom line is, if you don't understand an investment (or the advisor pushing it on you can't explain it clearly) don't be lulled by the promise of fabulous returns. Walk away. In so doing, remember this excellent definition of what hedge funds are really about:

Hedge funds: A way for fund managers to make unbelievable profits by convincing wealthy investors, pensions, and trusts, they have discovered a way to achieve high returns without commensurate risk. Qualifies as one of the greatest wealth transfer vehicles in modern times.

The only free lunch in investing is rebalancing (taking regular profits on those parts of your portfolio that have done well, buying into those that haven't). Anything else is illusory and will end in tears.

In the end, those that invested with Madoff and his ilk paid the most fabulous, unimaginable price for their investment lunch. Don't get this kind of indigestion with your money.....

{The above is solely the opinion of Nick Lincoln. It is not individual financial advice and should never be taken as such. If you wish to discuss the issues raised in more detail, please make contact with Nick. If you ignore this small print and act on his opinion(s) without first seeking financial advice or reading at least 100 pages of Key Features Documents containing numerous risk warnings, you may well be struck down by lightning}