Be Wise to the Next Madoff

Bernie Madoff -- could there be a more apt name for someone who "made off" with so many people's money? I hope he didn't steal any of your money, and I'd like to point out a few ways you might avoid getting Madoffed by someone in the future.

For one thing, it seems that Mr. Madoff promised some investors returns of up to 46% per year. If anyone ever suggests to you that you might count on earning that much, don't believe them! Here's a much more honest kind of guidance from a money manager -- Warren Buffett of Berkshire Hathaway, writing in his 1997 letter to shareholders after posting a 34% gain in book-value in 1997: "Our rate of progress in both investments and operations is certain to fall in the future ... At our present size, any performance superiority we achieve will be minor."

After Buffett's cautions, he went on to post a 48% gain in book value per share in 1998. Still, he was right to not promise any kind of outperformance.

Expect inconsistency
That's because the stock market doesn't work like bonds or CDs or savings accounts. There is no promised return. In the short run, returns tend to depend on factors such as the economy, investor psychology, and the like. In the long run, they're tied to the performances of the companies in the market. Madoff is now famous for having delivered returns that were rather consistent -- around 10%, take a percentage point or two, each year. That should have made his investors suspicious.

Why? Because when you look at the past 15 years of returns for the S&P 500, you see huge jumps and dives. The index lost money during four of those years, including a 37% drubbing last year. It also gained more than 20% during six years.

Sometimes you'll see even more dramatic moves with individual stocks, too. Check out the volatility on these stocks:

Data: Morningstar.

While not all stocks are equally volatile, they all do move around somewhat -- even stocks like Clorox, which you might think of as being defensive.

The lesson? Be suspicious of consistency!