Commentary: Madoff scam shows that you can't bank on paper gains

Commentary: Madoff scam shows that you can't bank on paper gains
By Chuck Jaffe, MarketWatch
Last update: 1:50 p.m. EST Jan. 14, 2009Comments: 23BOSTON (MarketWatch) -- "A billion here, a billion there, and pretty soon you're talking real money."
The line from the late Sen. Everett Dirksen is ubiquitous whenever there's a federal budget discussion, a Wall Street bailout or a public cost override, but it may not apply to the curious case of Bernie Madoff, the disgraced financier whose Ponzi scheme has cost investors untold billions that may not be real money at all.

While Madoff's case has deservingly dominated the headlines, the details have been sparse and unreliable. The media seems to have settled on the figure of $50 billion, but it's hard to know for sure because of the way most people calculate loss. In a here-yesterday/gone-today situation -- whether it's a fraud like Madoff or the 2008 nest-egg slashing gyrations of the stock market -- there's the amount of money that has been lost, and the amount of money that people think has been lost.
Discussing that distinction may help ordinary investors not only get through the current market turmoil with a different outlook, but also help them recognize why those people who cut corners on their due diligence or diversification when going whole hog with Madoff need to blame themselves for some of their problem.
Counting twice
For proof of the way most people view loss, look at virtually any interview with a Madoff victim, especially those where their tale amounts to: "Yesterday I was a millionaire and today I'm broke." I am not blaming the victims here -- rich or poor, they're living through every investor's nightmare -- but there's a very real concern that they are valuing their losses based on the peak and not on the deposit. See related story on the lessons of Madoff's Ponzi scheme.
Right up to the day when Madoff's scheme collapsed, investors were getting statements showing what their accounts were "worth." Obviously, they believed that money was on account somewhere (and some of it may have been, that is still being determined).
But if the statements were false -- and they were -- then the investors' claims of losses are exaggerated.
"People count the losses from the ostensible high point, not from the money they put in," said Terrance Odean, a University of California at Berkeley professor who studies investor behavior. "You don't get much benefit out of losing money; you might as well get full bragging rights."
Here's the difference between reality and "bragging" on these numbers. We'll keep the math simple. Say an investor put $100,000 with Madoff a decade ago and added the same amount each year since then. If you figure that Madoff's annualized "returns" averaged 12% -- a loose figure -- the first $100,000 deposit would have been "worth" around $340,000 today. Do that math out over the entire 10 years of real deposits and faked growth with Madoff, and the investor would have close to $1.5 million in their account.
But their actual loss would not be from the fictional total on the account statement, it's the $1 million they deposited ($100,000 per year for 10 years).
Mad money
So those "distributions" and "gains" that were rolled back into the investment pool? They never existed (the good news there is that investors in taxable accounts may be able to get an adjustment from the IRS, although that won't help the charities that were scammed).
It's still catastrophic -- you're just as broke -- but the size of the loss is smaller than it feels like. And so is the amount of any restitution, payback, court damages and so on.
"When you look at it analytically, you have fictitious profits, you never had gains, and you're not entitled to something that didn't really exist," says Michael Unger, a former Massachusetts securities commissioner, now with Rubin & Rudman in Boston. "They're looking at a lifetime of savings, and it's gone. But in terms of what they are entitled to, it'll never be a dollar more than they put in, unless someone can prove that there actually were real investment profits here."
The distinction is important on many fronts.
Investors suing to recover losses, hoping for protection from the Securities Investor Protection Corp. or praying for any form of government bailout will have in their heads the figure they deserve, compared to the one they are entitled to (if, indeed, they are entitled at all; many Madoff investors got exposure to him through feeder funds and may have little or no recourse). They won't be satisfied getting "their" money back, they want to get back the amount of money they thought they had.
If there is a public tab to be paid, any action that guarantees investment profits would be a mistake; in fact, some of the financial advisers and fiduciaries who will be facing Madoff-related lawsuits will argue that investors are due less than they put in, because they would have lost money, on average, being invested elsewhere in the market over the last five years.
The same personalize-the-gains mindset -- calculating loss from the peak and not based on the invested amount -- is part of what torments ordinary investors these days. They may be long-term investors planning to plow ahead through all conditions, but they are focused on the 40% average loss from 2008, rather than the 2.5% annualized average gain over the last 10 years.
"When someone was getting ahead because their money was growing, they were looking at it saying 'This is great, I can retire 10 years ahead of schedule,'" says San Diego-based investment adviser Michael Stolper. "And now that they are back to where the plan suggested they should be -- when they are looking at retiring precisely when they originally expected -- they're counting their losses and looking for someone to blame.
"They're still ahead of the game," he added. "In fact, the Madoff victims would gladly trade places."
It will take years until regulators and investors can calculate the "real money" lost in the Madoff scheme. The trauma and resulting loss of investor confidence cannot be minimized.
Still, the dollar values involved should not be falsely maximized. If current market conditions and Madoff have proven anything, it's that investments don't come with a guarantee, and the consumer who lets their guard down today may be a victim tomorrow.
Chuck Jaffe is a senior MarketWatch columnist. His work appears in dozens of U.S. newspapers.