Diversify investments to avoid financial disaster - Lessons to be learned from Madoff scandal

Diversify investments to avoid financial disaster
By:Frank Szivos, Contributing Writer02/19/2009

As the dust settles from the alleged financial terrorist attack of Bernie Madoff, the high-powered money manager and scam artist, of innocent people's retirement funds, there's a lesson in this mess: diversify your portfolio to avoid disaster.

That maxim holds true for individual investors as well as the Town of Fairfield, which lost $42 million in this alleged Madoff investment scheme.
Michael Tucker, professor of finance at the Dolan School of Business at Fairfield University, points out that the fallout of Madoff could further drive average investors away from buying securities, and resort to hiding money under fireproof mattresses. The danger is fear of investing coupled with fear of spending can grind the economy to a halt.
"Diversification is one lesson we can take from this," Tucker said. "The stock market has been awful; people have seen their savings over the last six years (a high point for the market) wiped out. If you put money in a bank, the return is low, but you're insured to a certain amount. If people only save and don't spend, we perpetuate the vicious cycle were in."
The irony of the alleged Madoff scam is that it could happen again, Tucker said. In his opinion, to avoid another disaster of this potential, the government (Securities Exchange Commission) must step in to impose even tighter regulations.
"Transparency is needed," Tucker said. "There needs to be a monitoring of transactions. The SEC regulations are antiquated. Self-regulation doesn't work. However, it's impossible to monitor every trade. It could happen again."
John Gerlach, associate professor of finance at Sacred Heart University, pointed out that the SEC had examined allegations against Madoff several times, but never uncovered the so-called "uber" investor's scheme.
"The SEC was in there seven times, but never dug deep enough to detect the scam," Gerlach said. "We obviously need better trained and more diligent workers at the SEC. Unfortunately, you can rest assured this will happen again. People are greedy, and other are gullible."
It boils down to due diligence in whom you're investing with. Unfortunately, the average person typically has neither the time nor expertise to determine which investment firms are the most reputable.
Gerlach recommended three safeguards to protect against investment fraud:
*Never put significant amount of your assets with one investor.
*Check the auditing firm that management company is using to determine if it's known and respectable.
*Never believe an investment pitch that claims to always get 10-12 percent return annually. There's no such thing.
Nonetheless, Tucker emphasizes the alleged Ponzi scams (investment swindles where high profits are promised from fictitious sources and paid off with funds raised from later investors' money) are easier to pull off in strong economic times when the stock market is cranking out profits and everyone is reading their quarterly statements, thinking their money is growing and the future is bright. When there's a downturn, as exists now, investors start calling for their returns on investments, and money managers must pay up-typically the time when scams are detected.
As usual, the average investor takes the brunt in downturn in the market, which happened most recently in 1987 and in the '90's when the dot.com bubble burst. Tucker recommends that investors consider index funds as an alternative to stock picking. An index fund is a type of mutual fund or unit investment trust whose objective is to earn approximately the same return as a particular market index, such as the S&P 500. Over the long run, he said they tend to outperform stock picking, according to Tucker.
The Town of Fairfield also had its pension pocket picked in the Madoff scheme through investments with Tremont Investors and later MAXAM Capital Management, money managers that had invested in Madoff's alleged fraudulent scheme.
After a loss from the general downturn on Wall Street as well as the alleged Madoff fraud, the Town's pension fund, including police, fire and town employees, took a hit of a total of 18 percent overall from a high of $330 million to $238 million. Some of the loss in funds for more than 1,100 Town workers, was cushioned because the Town had overfunded the pension fund to the tune of 120 percent, and other investments, apart from those managed by MAXAM, fared relatively well during the recession, according to Ken Flatto, Town First Selectman.
Flatto described the loss in the investment fraud as terrible, but it could have been worse. He foresees only a slight increase in taxes ("maybe half a percent") to cover this loss.
"We're fortunate because this fraud, horrible as it is, the rest of our funds are holding up well."
The Town Pension Board, which consists of 15 members on which Flatto sits, paid MAXAM one percent annually to manage the pension money. As a result of the alleged scam, Flatto said the Pension Board will stick to its rule to invest no more than 10 percent with any one money management firm. "To me, that even seems high now," Flatto said.
What's more, the board will use its own auditors to double check investment reports. During the last two months, the Town is conducting an audit to review the status of other investments.
In reaction to the investment fraud, the Town also has retained legal counsel and plans to file suits within the next two weeks on behalf of the more than 1,100 Town employees affected by the alleged stock scam, Flatto said. Suit will be brought against hired auditors, advisors and managers who the Town claims should be responsible for negligence in detecting the alleged fraud.
"We've never seen anything like it," Flatto said. "We do believe that the legal strategy our law firm is pursuing will be successful in regain some part of our loss."

©Westport Minuteman 2009