An Investing Lesson From the Super-Rich

By now you've heard about the saga of Bernie Madoff, the former Nasdaq chairman and longtime investment manager who stands accused of losing as much as $50 billion of his investors' money via a Ponzi scheme. Crazy stuff, and we'll probably see more of it as the recessionary unwinding continues.

As details have emerged about Madoff's investors, I've noted that many of their stories have one or both of these points in common:

• The investment was made via an advisor of some kind.
• The investor invested without understanding the "split-strike" strategy Madoff claimed to be using -- much less how it could generate such consistent returns month after month.

Oh, and these investors had one other thing in common. In many cases, they were seriously rich.

Not surprisingly, it turns out that major league wealth doesn't automatically impart investment wisdom. Who knew?

Well, we could have guessed
The rich are a lot like you and me, it turns out, at least in the sense of having blind spots around financial issues. Excitement at the prospect of sizable, consistent gains; the lure of access to an elite, secretive inner circle; the choice to believe an authority rather than to understand firsthand -- these are all common tendencies, probably rooted deep in the human wiring, and we can all be tripped up by them from time to time.

But if there's one thing that I see tripping up investors over and over, it's this: They buy stuff they don't understand. Folks, that's the road to ruin. And as the experience of many Madoff clients shows, just because a professional recommends an investment doesn't mean you're off the hook. They may not understand it either. A lot of Madoff clients invested via funds of funds, essentially hedge funds (with hedge-fund-class fees) that invested in other hedge funds and similar vehicles. Those investors thought their huge fees were buying some world-class due diligence. Right now it looks like they were mistaken -- and I can already hear the lawyers mobilizing.

If you don't understand it, learn more or move on
A lot of us learned this lesson the hard way, firsthand, during the dot-com boom. If you don't understand the business model, there may not be a business model worth understanding. Or, the company may be a great investment, but if you don't understand its technology, its value proposition, and the competitive landscape, you can't say for sure -- and neither can your advisor.

Some companies we think we know pretty well, and the things we need to work on to understand seem straightforward. For instance, most reasonably sophisticated individual investors know Johnson & Johnson (NYSE:JNJ) pretty well. The company has several understandable lines of business, a deep commitment to research, a historically reliable dividend, and a tradition of excellent management. Slam dunk, right?

Odds are it is, but it's worth a check anyway. The kind of due diligence you'd do before buying would probably involve refreshing your understanding of its businesses, making sure that there are no major clouds on the horizon, and crunching some numbers. With a stock like this one, that should be enough.

But if I venture out and use the Motley Fool CAPS stock screener to get a list of small, five-star growth stocks, I get a list like this:

I know that a couple of these have been recommended by The Motley Fool's newsletters, and when I get a chance to read those recommendations I'll know a lot more, but ... do I know enough to invest in any of them right now? No! I'd never even heard of three of them. This is nothing more than a starting point for further research. Investing in a micro-cap company carries big risks, and I would need to understand these businesses in considerable detail before investing.

But there are folks out there who buy a stock simply because it popped up in a stock screen, or because a broker recommended it, or because everyone at the country club is buying it.

Don't be those folks. Occasionally those kinds of purchases work out, but more often, one ends up poorer, just like Madoff's clients. Hopefully some of them will end up wiser for the experience.

More about how to avoid common investing mistakes:

• 8 Common Investing Mistakes
• 3 Investing Mistakes You're Making Now
• Experts Agree: You're Investing All Wrong