Multiple Dates to the Same Escape Room- and Bernie Madoff

Want to impress a date with your knowledge?

 

Take a date to an Escape Room– one that you’ve already been to.

 

Escape Rooms are fun- a group of people review clues and decide to get out as a group. To dazzle a date with your knowledge, you could visit the room in advance, remember the answers, and rattle off some of them.

 

But is that really possible to know 4-5 Escape Room answers, and come up with them so quickly?

 

Probably not.

 

Eventually, your date may wonder if your skillz (with a “z”) are really legit. Skepticism can also serve you well when you invest.

 

Kicking the Tires

 

Tim Ferriss recently interviewed Ed Thorp, a successful former hedge fund manager. In 1991, Thorp was asked to review the investment portfolio of McKinsey & Co., the global management consulting firm. You know- kick the tires to see how things were going. Specifically, Thorp reviewed investments in the company’s profit sharing and pension plans managed by Madoff and Co.

 

So, what stood out?

 

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The Red Flag: Consistent Monthly Returns

 

Barron’s explains that one investment generated 1-2% monthly returns consistently for years- a track record going back to the late 1960s (over 20 years up to ‘91). That’s a red flag- here’s why.

 

1-2% monthly translates into a 10-12% annual rate of return. If the portfolio was invested in stocks, the portfolio manager might be able to generate returns similar to the Standard and Poor’s 500 (S&P 500), an index of large company stocks.

 

What return would the portfolio generate?

 

Investopedia states that the S&P 500’s “average annualized return since its inception in 1926 through Dec. 31, 2021, is 10.49%.  The average annualized return since adopting 500 stocks into the index in 1957 through Dec. 31, 2021, is 10.67%.”

 

Ok, so a 10% seems reasonable. But generating a 1-2% monthly return consistently isn’t possible, based on fluctuations in the index. In ’97 and ’98, for example, the total return on the index was around 30% each year, but in 2008 the index lost 37%.

 

Why are the manager’s returns so delightfully consistent?

 

McKinsey’s response “We don’t know exactly, they tell us that they won’t explain what their method is but we can show you our accounts.”

 

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Digging Deeper

 

The investment statements revealed that the Madoff bought stock, and used S&P 500 index options to hedge the risk in the stock price- and that the options trades always worked.

 

Peter Madoff, Bernie Madoff’s brother, was managing the investment firm at the time. He wouldn’t let Thorp in the door.

 

After digging deeper, Thorp found that a half of the index option trades listed in the statements simply didn’t occur. The options never traded at the prices listed on any exchange on day of the trade. Thorp confirmed the data with another brokerage firm and told McKinsey that the investment statements were fraudulent.

 

It took some convincing, but Thorp was able to get McKinsey to end the relationship and withdraw funds.

 

Why didn’t McKinsey believe the fraud immediately?

 

The Emperor Had Clothes- For Awhile

 

Bernie Madoff was a respected member of the investment community. He was the former chairman of the NASDAQ, served on many industry committees, and his firm was a large market maker in stock trading. He had thousands of investors, which added to his credibility.

 

Eventually, the emperor lost his clothes.

 

In 2008- 17 years after Thorp’s review of Madoff trading- the fraud was exposed. He operated the biggest Ponzi scheme in history, “defrauding thousands of investors out of tens of billions of dollars over the course of at least 17 years, and possibly longer. He died in prison on April 14, 2021 while serving a 150-year sentence for money laundering, securities fraud and several other felonies.”

 

The Lesson

 

It something seems impossible (or just unlikely), pause. How, exactly, is the person or business achieving these outcomes? If it’s a scam, they probably won’t tell you.

 

Food for thought.

 

 

Ken

 

Image: Escape, Predrag Djurovic