On December 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. In this role, Markopolos 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. And 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 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. And if that was the case, the only alternative was that this 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. And yet, none of these regulators took any action. Madoff was able to continue his fraud for another six years before it finally unraveled.
This week, Markopolos was 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.”
These new accusations came in the wake of renewed stock market tumult. On Wednesday, the Dow Jones Industrial Average lost 800 points. This equated to a 3% loss—hardly the worst day in percentage terms, but the headlines, nonetheless, were scary.
Economist Elroy Dimson once defined risk this way: “More things can happen than will happen.” In other words, 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. And even when there are signs, they are never easy to interpret. Consider GE: When Markopolos published his report yesterday, the stock dropped more than 10%. But today 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 is wrong this time despite being right last time? Without the benefit of hindsight, the investment world can be a confusing place.
So how can you protect yourself? Financial risk, in my view, fits into three categories. If you’re feeling rattled by this week’s events, I recommend “auditing” each of these aspects of your investments:
1. Overall market risk. Since 1997, the U.S. stock has doubled in value twice, quadrupled in value once and gotten cut in half (or worse) 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 just as easily highlight the risks as you could the opportunities. Consider Tesla. Its CEO is a genius, often compared to Thomas Edison. But he’s also demonstrated erratic behavior and been in trouble with regulators. And sometimes new risks materialize out of the blue, as they did with GE this week. 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 seems like it ought to be the most difficult to protect against, but in my view it is the easiest. For the bulk of your investments, avoid anything that looks esoteric and steer clear of private funds. Invest only in things that are straightforward, that have publicly-listed, easily-ascertained prices. And be sure your assets are held by a large, well known custodian—a firm like Fidelity or Charles Schwab, for example. You didn’t need to do any math at all to see this as a huge red flag for Madoff.