Do you know what your money is doing?

Great article by Sy Harding:

The $50 billion Bernard Madoff investor fraud situation has a number of lessons for investors painted on a large enough canvas that they should sink in.

I've been appalled by the number of intelligent and successful people, trust funds, foundations, and charities that had a huge percentage of their investment portfolio, in some cases all of it, in Madoff's fund, without even understanding what his strategy was supposed to be (if he had bothered to actually make the investments rather than just using new incoming money to pay a return on earlier money, in a classic Ponzi scheme). No thoughts of diversified holdings?

I'm guessing that a very high percentage of investors using a money manager also make the choice based on no more than that he is a member of their church or country club who seems like a nice guy, or was recommended by someone in their church or country club who say he is a nice guy. Almost no one does any actual due diligence before turning over their money.

It's surprising that such sophisticated people, even other hedge funds and banks that put money in Madoff's fund, loved the 'smooth' annual return every year, and were not suspicious even though they could not come close to producing a steady 12% annual return themselves.

Without doing any investigation or thinking about how they have seen the market act, that is the normal expectation of investors managing their own money, that the market makes 12% a year, and they should be able to do at least as well. It is also the standard promise investors believe has been made to them when they are told by a prospective money-manager that the market's average annual return for the last 100 years has been 12% or whatever. Of course, the devil is in the details, in that word 'average'.

In some years, as in 1998 and 1999, the return might be 26% or 28%. (The Nasdaq gained 85.6% in 1999 alone). But in other years it will be down 20%, or on rare occasions like this year, be down 30% to 50%. Yet it will average a gain of 12% a year over the long-term.

Yet no one seemed to question Madoff's fund returning 12% or whatever it was every year, even through the bear markets of 2000-2002 and this year, as well as in the bull market years when the market gained 25% or so. Impossible.

The only way you can avoid the large losses while still making most of the big gains is through market-timing. Yet even in a successful market-timing strategy the gains will not be smooth.