ON DEC. 17, 2002, Harry Markopolos walked out of his Boston office wearing an oversized trench coat and a pair of white cotton gloves. His destination: the John F. Kennedy Presidential Library.
A quiet figure, Markopolos worked as the chief investment officer at a small firm that specialized in trading stock options. He had heard about a New York-based competitor that was apparently doing similar work, but with much greater success. Following his boss’s recommendation, Markopolos tried one day to replicate his competitor’s strategy. But when he did, a funny thing happened. He realized that he couldn’t—not because he wasn’t capable, but because it simply wasn’t possible.
As Markopolos tells the story, it was just five minutes before he began to suspect something fishy about the New York firm’s numbers. By the end of day, with just a little more work, he was sure of it. So sure, in fact, that Markopolos decided to alert the authorities.
Markopolos prepared a detailed written report. His objective that December day: to hand deliver it, anonymously, to the New York State Attorney General, who happened to be speaking at the Kennedy Library.
Markopolos’s analysis was dense, packed with math. But the bottom line was clear: It was mathematically impossible for the New York firm to be doing what it claimed to be doing. If that was the case, the only alternative was that the firm—Bernard L. Madoff Investment Securities—was a giant fraud, running the world’s largest Ponzi scheme.
In Markopolos’s words, he “gift wrapped” the Madoff case for the government. In addition to the New York Attorney General, Markopolos also contacted the SEC. Yet none of these regulators took any action. Madoff was able to continue his fraud for another six years before it finally unraveled.
Markopolos was recently in the news again—this time with fraud accusations against General Electric. On a newly launched website, Markopolos argues that, “GE Is Headed Toward Bankruptcy.”
Economist Elroy Dimson once defined risk this way: “More things can happen than will happen.” The world is an uncertain place. Some things are easy to predict, but most aren’t. Sometimes, there are warning signs—such as Markopolos’s repeated attempts to get regulators’ attention. But sometimes—maybe most of the time—there are no warning signs at all.
Moreover, even when there are signs, they’re never easy to interpret. Consider GE. When Markopolos published his report, the stock dropped more than 10%. But the next day, it made up most of that lost ground. What should we make of that? Are we ignoring Markopolos again at our peril? Or is it possible that he’s wrong this time? The investment world can be a confusing place—and often only makes sense when we look back months or even years later.
So how can you protect yourself? Financial risk, in my view, fits into three categories. If you’re feeling rattled by recent events, I’d recommend taking your portfolio and “auditing” it for all three risks:
1. Overall market risk. Since 1997, the U.S. stock market has doubled in value twice, quadrupled in value once and gotten cut in half twice. Where it goes next, no one can say. Fortunately, the solution to this risk is relatively easy: appropriate asset allocation.
2. Individual investment risk. Sometimes, you can spot a risky investment from a mile away, but it’s rarely that easy. Investments are more like Rorschach tests. For any given investment, you could highlight the risks or you could highlight the opportunities, depending on whether you’re predisposed to like the investment or not.
Sometimes, new risks materialize out of the blue, as they did with GE. Fortunately, the solution to this risk is also straightforward: diversification. Keep your bets small so you can’t lose too much the next time Harry Markopolos puts on his trench coat and white gloves.
3. Fraud risk. The last category of risk might seem like the hardest to protect against. But in my view, it’s the easiest. For the bulk of your investments, avoid anything that looks esoteric and steer clear of private investment funds. Invest only in things that are straightforward and that have publicly listed, easily ascertained prices. And be sure your assets are held by a large, well-known custodian—a firm like Fidelity Investments or Charles Schwab. This was the huge red flag with Madoff—and you didn’t need a degree in advanced mathematics to see it.
Adam M. Grossman’s previous articles include Room to Disagree, Never Mind and Double Checking. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.