Tuesday, January 6, 2009

Who Can You Trust?

It wasn't greed that led psychologist Stephen Greenspan to invest 30% of his savings in a hedge fund that fed his assets to Bernard Madoff. It was sloth.

Writing in the Wall Street Journal Greenspan attributed his poor judgment to: "my profound ignorance about finance, and my somewhat lazy unwillingness to remedy that ignorance." Link here.

Since Greenspan literally wrote the book on gullibility, it is ironic to see that his advanced academic understanding did not prevent him from becoming a gull.

Some would say that Greenspan placed too much trust in the wrong people, but I think that, in fact, he was investing on faith as much as on trust.

When you invest in something you know nothing about you are acting on faith. And when you are assuming that the future will always replicate the past, you are acting on faith.

Trust may be the basis for community. It is the basis for judgments about a person's character. And yet, if the Madoff debacle tells us anything, it tells that people who thought they were trusting a friend and a colleague were, in fact, investing on faith.

You might trust a friend to do as he says he will do. But, the concept of due diligence means that you cannot make an intelligent investment decision based on someone's word. If someone gives you his word that he will always have superior investment returns, he is abusing your trust.

Simply put, his word might well control his behavior; it can never control the markets. When an individual is trustworthy, that means that we can reasonably predict his future behavior. When he says he will be there, the probabilities are very high-- if he is trustworthy-- that he will be there.

And yet, a market is subject to so many different forces that it is impossible to predict with any degree of certainty where it will be in the future.

A market cannot promise to provide for your future. Only an individual running a Ponzi scheme can fulfill a promise to provide you with predictable returns... until, of course, the scheme runs aground.

Since the market does not give its word, you need to do due diligence. You need to verify the information you have received, assure yourself that the facts are true as represented, and evaluate the risks.

Of course, few people are sufficiently savvy to be able to evaluate investment risk. Many hire investment advisory and placement firms to do it for them. If they had hired Goldman Sachs or Merrill Lynch they would have been told to stay away from Madoff.

If, however, they had invested through the Fairfield-Greenwich Group, they had a right to expect that the firm would live up to the promise in its prospectus-- to do the most thorough due diligence before placing anyone's assets anywhere.

In that case people were not investing on faith. They were trusting a firm to do as it said it would do, and as was within its power to do.

If the managers of feeder funds did not do the due diligence they claimed to have done or if they did it poorly, then they will surely answer for it in court.

I for one would hate to be a fund manager standing in court explaining to a judge that I was too lazy or preoccupied to do the due diligence I had promised my clients.

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