The first line of defence against fraud

If you find an investment that you feel comfortable with, it may be very tempting to park all your money in it, stop worrying about it and get on with your life. This is unwise, because if the investment goes bad for any reason, you may lose everything. Time and again in investment scandals we hear of people who ‘lost their entire life’s savings’ in a single investment. Sometimes this is a journalistic exaggeration. The actor Kevin Bacon, for example, was reported as having lost everything in the Madoff fraud, but he has subsequently explained that he had only lost the majority of his financial assets, and still retained other assets, such as his home. So we need to be clear about what we mean by ‘life’s savings’; does it just mean your cash and near-cash savings, or all your financial assets, or your entire net worth that you have built up over a lifetime of work, including your house and your pension rights? Most often, people seem to be referring to the financial assets over which they have direct control when they say ‘life’s savings’, excluding other valuable assets such as property and a pension. So if you are living in a £1 million house and you lose £100,000 in a fraud and have no cash left, you are clearly not as badly off as someone who sold their £1 million house and put everything, £1.1 million, into an investment that collapsed. There are other considerations, too. If you lose everything when you are 20, you have a lifetime to earn some more, but if you are old or sick, you may have no hope of escaping penury.

In 2009 a retired British soldier, Major William Foxton OBE, who had lost an arm on active service, shot himself after reportedly losing his ‘life’s savings’ in two hedge funds that had invested with Madoff. The full financial details in this tragic case have not been divulged – and it is none of our business – but perhaps we can hope that Major Foxton owned a house and was in receipt of a pension, and that these had not been lost. Nevertheless, we can suppose that a very substantial percentage of his net worth had been lost in the Madoff affair. But investing all your financial assets in two funds is not a lot better than investing it all in only one fund, and in this particular case, the two funds appear to have flowed into the same black hole with Madoff.

Unless you love to take insane risks, if you ever lose a very large part of your wealth in a single fraud it will usually be one that you did not anticipate. The fraud that gets you is the one you didn’t see coming.

So it makes no sense at all to put all your financial assets into one or two investments, unless you are just starting out and only have a very small sum to invest. Nor, incidentally, does it make sense to have all your wealth exclusively in financial assets (see ‘Asset allocation’, below). You need to spread your wealth across different investments to reduce the risk of being wiped out by a major fraud.

Investment advisers talk a lot about diversification, but in general they are focusing on how diversification reduces other kinds of risk. The trouble with fraud risk is that it can happen anywhere in the process, and the investment advice industry doesn’t like to talk too loudly about it, because it frightens customers away. Regulators such as the FSA and the SEC do provide useful guidance on fraud prevention on their websites, though, and it is worth reviewing this material at regular intervals because new scams are always popping up.

So, how much should we diversify our financial investments? The standard answer for direct investment in individual shares is that investing in 12 to 18 different companies is sufficient, but most people don’t like to invest in individual shares; they like funds. Funds are supposed to have all kinds of benefits, including good diversification, but with the growth of hedge funds and other exotic types of funds in recent years the picture is becoming ever more complex and, as we have seen, the majority of funds do not perform particularly well in the long term (in fact, many funds don’t even last very long before they are closed down). In the current environment there also seems to be a substantial increase in the risk of fraud in the fund universe, which is very disturbing. If you are going to invest in funds, therefore, it may be sensible to spread the fraud risk by investing in several funds, not just one or two, and to ensure that these funds are not closely associated with each other (for example, make sure that they are not all owned by the same institution).

One way to look at this problem is to say to yourself, ‘in the unlikely event that one of my investments goes belly up because of fraud, what percentage of my net worth can I stand to lose?’ Saying ‘0%’ is not an acceptable answer, because there is always some risk, however small, of fraud in any financial investment. Suppose you had invested only 10% of your financial assets in Madoff; the loss would have been nasty, but it really wouldn’t have been the end of the world. You might even feel rather happy about it, considering that so many other people lost so much more. I was caught out during the dotcom boom when I put £10,000 into Marconi, a telecoms and aerospace conglomerate. The price doubled within a fortnight, and I should have sold, but I didn’t. Within months the company had collapsed and the shares were suspended. Two years later, after the company was ‘restructured’ (essentially, it was taken over by its creditors who received 99.5% of the new shares), I was sent a cheque for, if I recall correctly, £1.50. These things happen. Although it was very annoying (I still suspect wrongdoing) the money I lost was a small proportion of my overall assets, so it did not destroy my life.

It is a good approach to spread your investments around to the point where one of them failing isn’t going to ruin your life, but it isn’t quite enough. Consider this: suppose you put all your investments through one single adviser, or only buy products from one massive bank. You could be back to square one if your adviser embezzles the money or the bank collapses.

The answer is to conduct a careful risk assessment just for the possibility of collapse due to fraud. If you work in the UK, you may well have encountered health and safety risk assessments at work, and these can be usefully adapted for this purpose. For example, in a workplace health and safety risk assessment the first thing you have to do is identify the hazards by walking around the office looking for things that might hurt people – you can do something similar by mentally walking through all the different organisations and processes involved in your investments. You can evaluate the risks you identify, rank them in order of the harm they could do to your wealth, and assess the measures you can take to prevent them or mitigate their effects. You should include all the investor protections provided by regulators and compensation schemes, so, for instance, you would note that your cash deposits in a UK high street bank are, at the time of writing, protected up to £85,000 by the Financial Services Compensation Scheme. There are some foreign banks in the UK that are not covered by the scheme, so you need to look at the details of the scheme on the FSA’s website to make sure you are covered. Icesave, the Icelandic online savings outfit, was not covered by the scheme when it went bust. Write it all down on a risk assessment form and keep it – it’s amazing how often little details change. Review your risk assessment form periodically and update it. This may seem boring and bureaucratic, but financial investment is all about the little details. If you get the little details wrong you can lose out badly, so take the trouble to do a good job. Incidentally, just because there is a compensation scheme it doesn’t necessarily mean you’ll get your money back quickly, so include that problem too in your assessment.

Lower your expectations

Many of us have a completely unrealistic idea about what kind of returns can be achieved on the stock market, or in financial investments generally. This is partly because people who work in finance seem to earn so much money; we never stop hearing about twenty-somethings being given an annual bonus that could buy a substantial house outright. It is a misleading picture, because many financial workers are paid much more modestly. Traders, especially derivatives traders are highly paid and often young; typically they start out (currently) on a salary of £30,000–£45,000 and don’t earn the really big bucks until they have much more experience. Many of them don’t make it, either because they are fired or because they can’t stand the work any more.

Elsewhere in the industry, it is really the fund managers and senior executives who make the big money. Much of this money is derived from the charges they impose for managing money, and not really from investment success. Consider a fund that is set up by a large institution to give ordinary investors the opportunity to participate in a sudden economic boom in, let’s say, Ruritania. The fund runs for a few years, performs poorly, and when the Ruritanian economy collapses the fund is quietly shut down or merged with another fund. The managers have probably been paid very well – out of investors’ money – to deliver very unimpressive results. In short, much of the big money earned by finance professionals comes from managing other people’s money, and not from investment success. And all too often, as became clear in the sub-prime crisis in the US in 2007, finance professionals have been paid very well to operate dishonest schemes that eventually collapse. It is not really investment success, for example, to sell a lot of mortgages to people who can’t afford them and will eventually default, or to bundle those toxic mortgages with other assets and then sell them much too expensively to other investors, especially if these practices bring down the whole sector and set off a major worldwide crisis lasting for years.

Another reason why many people have unrealistic expectations about investing in shares is they constantly hear stories about a particular share that has gone through the roof. If you look at the historic chart of such a share price, you see that at times, sometimes for years, the price has just gone up and up and it is easy to think you could have jumped in at a low point and jumped out at a high point with a huge profit. This is indeed possible on some occasions, but many studies show that overall this approach, which is a primitive form of market timing, does not produce good results. Furthermore, as outsiders, private investors have to pay much higher transaction costs than the professionals do, so frequent buying and selling will tend to bring your overall returns down.

So what kind of returns can we really expect if we take a sober, long-term approach to investing in equities (shares)? One famous study by Elroy, Dimson and Marsh finds that over the very long term, for example 1900–2011, most industrialised economies have generated a positive real return in their stock markets, but the average annual real rate of return has been quite low – in the region of 5%. This includes many years when returns have been negative, so in practice if you bought and held a representative sample of a stock market, for instance through an index tracking fund, you would find that in some years you got a much higher return and in some years you would have ‘lost’ money as prices dropped from the previous year’s level – this is why investors in shares are advised to hold for as long as possible, to iron out the ups and downs. This is all actually quite good news, especially as the long-term return from bonds has been considerably lower, and in some cases has been negative. Over the very long term, then, equities have proved to be the best-performing financial asset type.

Many people scoff at the idea of only being able to obtain an average annual real return of 4% or 5% over the long run, but this is the level that pension funds, which are generally conservatively managed, tend to aim for. Of course, there are times when you make more, but there are also times when shares do very badly; share prices are ‘volatile’ (they go up and down unpredictably).

If you want to achieve a better return, you have to take on more risk by investing in shares that are much more volatile than the average. This is all very well, but share investing is not like playing a computer game when you can restart if things go wrong. If you invest for, say, 20 years in risky shares, you may do unusually well, but you may also do very badly indeed, and if that happens you can’t undo your losses.

You can find a fuller discussion of these matters in my book How the Stock Market Really Works. For our present purposes, the bottom line is that lowered expectations and a long-term conservative outlook will help protect you psychologically from many of the temptations of investment, both fraudulent and otherwise.

Asset allocation

Asset allocation is all about looking at your whole wealth as one big potAsset allocation is an important concept for private investors. It is fairly plain that most of the people who lose their ‘life’s savings’ in a fraud do not practise asset allocation effectively, if at all, so it is worthwhile learning something about it.

Asset allocation is all about looking at your whole wealth as one big pot, and considering how to divide it between different types of investments with the aim of getting the best return overall without taking more risk than you can handle. One of the most surprising features of careful asset allocation, which has been refined in recent years, is that it is possible to use it to obtain the same or better returns at a lower level of risk than if you just put all your money into equities. Using asset allocation you can achieve smoother, steadier returns than you could otherwise (another way to say this is that the returns have low volatility). One of the big attractions to investors of Madoff’s scheme, remember, was that he claimed to be generating very stable returns. While asset allocation cannot actually produce the same degree of low volatility as Madoff was pretending to achieve, it can definitely take your returns in that direction.

This is done by exploiting the fact that different types of asset (such as shares, buildings, bonds and commodities) tend to have a low correlation with one another. For instance, sometimes bonds will be performing quite well, while shares are performing very badly, and at other times the opposite will occur. The correct mixture of shares and bonds alone can lower the volatility (which is a proxy for risk) in a portfolio, and you can achieve even better results by carefully selecting a wider range of asset types in different countries, currencies and markets that are negatively correlated with one another.

The technicalities of how best to do this require specialist expertise and a knowledge of your specific personal circumstances. Sadly, the more ruthless financial professionals are ahead of you, and may try to confuse you by offering products that are supposed to give you this kind of low volatility but in actual fact do not.

Also, the theory tells us that you have to ‘rebalance’ your asset allocation every so often because over time elements in your portfolio will have grown at different rates, altering your risk exposure. To rebalance, you sell some investments in some asset classes and buy them in other asset classes to bring your portfolio back in line with your original asset allocations and keep the risk steady. One benefit of this is that when you rebalance you tend to sell investments when prices are high. There is one thing to watch out for – an unscrupulous adviser who tries to rebalance your portfolio too often to generate fees. This is called ‘churning’, and although churning is not permitted by the regulators, it is very hard to prove, so be careful in your choice of adviser.

If this approach seems interesting, you can find out much more from the work of Dr Craig Israelsen, an Associate Professor at Brigham Young University in Utah who is a leading expert on asset allocation for private investors in the US. He is also an extremely clever, humble and honest man, which makes a very nice change from the dreary bunch of finance professionals that so many of us have to contend with. For more information, see his website (at: www.7twelveportfolio.com).

Staying sane in the investment jungle

There is plenty that we investors can do to reduce the risk of suffering a damaging loss through fraud, and we owe it to ourselves to do as much as we can. Too many investors focus all their time on how to get the best return; we should spend at least as much time on figuring out how to reduce the risks, not only of outright fraud but also of all the other factors that can lead to investment losses. We need to keep on educating ourselves on financial matters, and to learn from a wide range of sources, not just our favourite newspaper and the TV news, but we also need to be able to relax, and be a little philosophical.

Although he has not confirmed this, the actor Kevin Bacon is reported to have lost $50 million in the Madoff affair. Ouch! But Bacon has displayed some real backbone in discussing the loss publicly. As he points out, he still has his health, a home, a family and a career – a lot to be grateful for. Life can go on, even after such a massive setback. Maybe we should take a leaf out of Kevin Bacon’s book; ultimately, there really are many things that are more important than money.