Terms like hedge fund, are nouns; static things. Profits are explained by verbs or actions along the lines of the MacCawber equation in David Copperfield by Charles Dickens; “make sure your expenses do not exceed your income.”

Many schemes make absolutely no attempt to explain the actual source of the proposed profit, apart from the concept of a spontaneous increase in the price of the so-called asset. The concept of capital gain can apply to a betting ticket should your horse win. All other capital gain schemes are actually a variation on this model. In the casino, some patrons win and some lose.

As Galbraith noted, in a good boom, the concept of recurrent yield is completely forgotten; let alone any evaluation of the future reliability of that yield.

Another clue arises from understanding how the proposed process is adding value. In a boom, apparent past performance tends to create Gurus whose opinions displace arithmetic value-adding as the basis for judging an investment. Past profit does not prove an added value; it can indicate fraud or patronage from a powerful elite who are running the scheme. Without Mr Ponzi’s fraudulent manipulation there would be no hint of a profit, because no real value-added profit is being achieved.

Currently in Australia, real estate netting less than 5% (without capital gain) and equally overpriced shares fit the above definition of unwise investments rather well. The Bear Market still has a way to go yet, except for the foolhardy who are seeing bargains by comparing today’s prices with yesterday’s. Those who are using tomorrow’s yields as the yardstick are likely to stay on the sidelines for a little longer. If you can’t put your shares in a drawer and live off the dividends, be very careful.

Admittedly, mine is a rather boring,conservative strategy, which often means I have little to contribute to dinner party conversations about exciting opportunities to make money without working. The latest scheme seems to involve watching the price of your shares move up and down on a computer screen and jumping ship when the trend line turns. Good luck, when George Soros decides to have a bit of fun with his billions of liquid capital.

My answer: not possible

Think about it.

Human intercourse is based on trust.

When we meet someone first time we give them benefit of the doubt for being who they say they are. We do not ask them to whip out their drivers license to show us a picture id confirming that the person who is in front of us is who they say they are. And even if we did that, we could still be fooled, if someone impersonated themselves by forging the picture on the drivers license.

This example is just to give an idea of the scope of the problem if trying to completely prevent future deceptions by the Madoffs of the world.

Our entire society is based on an assumption that the person, or institutions we are dealing with are, in fact, who they represent themselves to be.

Absent operating on such assumptions, nothing could happen in a society as we would be spending all our time confirming what someone said, or did; instead of moving on and acting on such representations.

Think about how many interactions you have daily which are based on assumptions that you don’t have to do a separate individual ‘reality check’ everytime you interact with someone.

Based on the way our world is organized, we – the 99.99999999% of us who abide by the rules and assumptions of our society – go about our business daily operating on the assumption that the other 99.999999% of the population is like us, also rule oberving.

The problem is that if a person like Madoff or an organization like Enron chooses to ‘game the system’ by not playing according to the rules we will miss it – if done carefully; as Madoff and Enron were able to get away with their illegal behavior for so long.

So, while President Reagan may have proceeded on the maxim: ‘Trust but verify’ – its easier to say than do, when dealing with everyday things.

If we didnt trust each other – ie take each other at ‘face value’ our commerce will slow to a crawl while we ‘prove’ every statement made by every person we encounter in our daily life.

If we do trust each other at ‘face value’, we open ourselves up to the inevitable possibility that someone we meet may not be the ‘genuine article’ – ie like Madoff.

Its a chance we have to take everyday. Its a cost of being alive.

Tom Williams

A victim of a Ponzi Meister 15 years ago, who stood in a long line of ‘financially sophisticated’ creditors in Bankruptcy Court.

If neither choice can be trusted, you’re on your own. Recent events have certainly impaired both groups, I think.

But to your question, I agree that it is perfectly reasonable that an individual would
be taken in by this. After all, Warren Buffet has been chalking up more impressive
returns for a longer period of time than Madhoff, so there is evidence it can be done.
I have a harsher opinion of those who over allocated to his fund, however. The
person who put all or nearly all, or even 30%, of his cash with Madhoff is guilty of
the greatest level of gullibility – believing that he knows what he doesn’t know.

As you point out, diversification is the answer. But speaking more deeply, it’s about one guarding against his own inability to know by taking precautionary steps such as diversification, even if it means giving up attractive performance. Incidentally, this is where I disagree with Greenspan’s analysis. He says that he doesn’t believe he was being greedy because he wasn’t looking for “get rich” returns, but in the context that I speak, he was greedy because he invested too much money on the “best hoarse.”