Eyes Bigger Than Stomachs

Money has a peculiar property: if you don’t want or know how to manage it, somebody else will happily to do it for you and play you for fool along the way. As if there was a shortage of Wall Street scandals last year, there’s always room for one more. I’m referring to the freshly baked ordeal with Bernard Madoff and his clever scheme of siphoning off billions of dollars.

In the earlier scandals and the subsequent socialist-style bailouts of financial institutions, stupidity, greed, arrogance, etc, were the token accusations. True, banks are not there for you, only for themselves. However, here’s something that caught my attention in a recent WaPo article, Madoff Case ’Failures’ Put SEC in Spotlight:

Madoff attracted investors by promising steady returns with almost no risk of losses. He quoted a long-term average return of 1 percent a month and 12 percent a year, according to materials distributed to his clients.

It was a spectacular and improbable track record. Measured by a Wall Street ratio that compares risk and reward to evaluate hedge funds, investing with Madoff was more than a sixfold improvement over simply investing in the broad-based Standard & Poor’s 500-stock index.

Michael S. Meade, chief executive of Lampost Financial Group, a brokerage and hedge-fund manager, said one client who had invested with Madoff asked him for an evaluation. He investigated, then cautioned the client, saying the results were implausible. The investor remained with Madoff.

Fantastic returns, promises of improbable returns, a warning of a hedge-fund manager—and yet people stayed. Eyes bigger than stomachs. Those who ignored big red flags deserve what came to them.

For hundreds of years, since the tulip mania and South Sea bubble, investors have been acting the exact same way. Yet they still fail to understand that nobody is able to predict the future, nobody has consistently produced such improbable returns over a long period of time (Peter Lynch quit too soon to tell), and that there is no such thing as low risk and high return.

Become an educated investor

Pardon my insistence, but I’d like to very strongly recommend a couple of outstanding personal finance books. They don’t contain mysteries of get-rich-quick investments (there aren’t any); they don’t list “10 easy steps” to comfortable wealth. What they teach you is how the system works and how it’s been playing you so far.

1. The Four Pillars of Investing by William Bernstein. Of all personal finance books, this one is my favorite. Easy to digest. Balanced on the history of investment mood swings throughout history, discussion of risk tolerance, and various financial “vehicles” at your disposal. A great place to start!
2. A Random Walk Down Wall Street by Burton Malkiel. Once you’re done with the Four Pillars, put Random Walk on your reading list. It’s a very thorough look at the financial industry, lots of studies of historic performances of various investing strategies, and a lengthier overview of securities you can invest in.
3. The Total Money Makeover by Dave Ramsey. I’ve listened to Dave Ramsey’s Financial Peace University live recordings and learned quite a bit. I do get annoyed with his motivational speaker style of presenting and constant references to The Bible, but I’m willing to cut him some slack: the guy genuinely tries to help.
4. Fooled by Randomness by Nassim Nicholas Taleb. You can find my review of this title here.

Be the master of your own money, or somebody else will.

Good luck!