In a recent made-for-TV movie actor Richard Dreyfuss plays hedge fund manager Bernie Madoff, creator of one of the all-time great Ponzi Schemes. A Ponzi Scheme, named after an Italian crook of the early 20^th century, is a fraud in which a proprietor (like Bernie) accepts money from investors based on a claim to be able to generate investment returns when, in fact, there is no intent to invest at all. Bernie’s pretense was that he was a brilliant and experienced options trader. He claimed that his proprietary investment strategy, called “split-strike conversion” had the ability to generate high and steady rates of return regardless of the business cycle or overall market performance. He kept the details of the strategy hidden from investors; after all, it was proprietary.

Bernie had a combination of reputation (apparently he did build a successful securities company which was managed by his sons), excellent track record (which was faked), charm and psychological mastery that generated great enthusiasm by people eager to be “allowed” to invest in his fund. And so long as incoming funds from new investors were greater than demands by existing investors to take cash out (these redemptions were fairly small because people didn’t want to miss out on the great future returns), the fraud could be perpetuated. In Bernie’s case, this meant for 40 years.

It is unclear in the movie and also in the news reports whether Bernie actually tried to manage a portfolio at the outset and failed to produce good returns, or whether the fund was a fraud from inception. In any case, it became a fraud and was doomed to fail eventually. The beginning of the end for Bernie was the Bear Stearns collapse in early 2008. This prompted investors all over the world to attempt to reduce the riskiness of their portfolios and to extract cash where possible. This meant an increase in desired redemptions in Bernie’s fund, and he had to really hustle to bring in hundreds of millions of new cash to meet redemptions (knowing all along that these new ‘investors’ were going to lose 100% of their investments). By the end of 2008 the rush of redemptions overwhelmed new cash inflows and Bernie confessed to his sons that the fund was a fraud, and the sons turned him in to the authorities.

What was the total loss? The headline number is over $60 billion, but that includes decades of false returns. Roughly speaking, Bernie claimed to produce returns of about 1% a month. Suppose the fund started with $500 million of client investment and “earned” 1% a month for 40 years. This would accumulate to $59 billion. But of course if, as did occur, instead of investing Bernie used the $500 million to support a lavish life style, then there would be nothing left of the original investment. So what was the loss? Would it be the initial investment of $500 million or the fake accumulation of $59 billion, or something in between?

A court appointed attorney, James Picard, was tasked with recovering as much as possible from Madoff and his accomplices. It turns out that total amount invested in the fund over the years was $17 billion, much of which had been withdrawn before the failure. Picard used the principle of “fraudulent conveyance” to sue anyone who took out from the fund more than their initial investment. He also sued so-called “middlemen” who put client assets into the fund in return for large fees. In total, Picard collected over $9 billion, just about half of the funds that had been invested (but less than 20% of the stated value of the fund at its demise).

Anyway, the overriding problem is that Bernie appeared on the surface to be a very successful investor. People believed his high reported returns and assumed they would continue. As more people invested, Bernie appeared to be more successful, and this only made other investors more eager to climb on board. This is an example of a positive feedback loop that ends in disaster. What can people do to protect themselves from this sort of thing? There are a few bromides which may be applicable here, like “if it looks too good to be true it probably is,” or “be fearful when others are greedy and greedy when others are fearful,” or “if a trend is unsustainable, it will come to an end.”

But the problem is that it is very difficult, nearly impossible, for the ordinary person to assess the degree of skill or even the honesty of a potential investment advisor. Still, the ordinary investor can take precaution against fraud. One strategy is to make sure that there is segregation between investment discretion and custody of the funds. That is, if you choose to give discretion to a portfolio manager A, make sure that the funds are held at unaffiliated custodian B. Bernie’s investors failed to do this, allowing Bernie and his accomplices to produce bogus investor reports and financial statements. These financial statements were rubber-stamped by a small New York Accounting, whose sole proprietor was charged with fraud and eventually settled with the prosecution. If you hand over your money to someone else to manage, you have to do some due diligence.

A simpler solution is for you to take responsibility for management for your own portfolio.   One relatively painless way to obtain broad diversification and overall market exposure is by investing in one or more low-cost index funds. This strategy will likely outperform most professional advisors and is far less likely to be subject to an enormously negative “black swan” event as experienced by Bernie’s investors.