Caveat Emptor

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In a book by Diana K. Henriques, The Wizard of Lies: Bernie Madhoff and the Death of Trust, we read of a stockbroker and investment advisor who perpetrated the largest financial fraud in U.S. history. Toward the end of Henriques’s book, on page 341, she writes: “With his ability to disarm even the most sophisticated institutional investors, Bernie Madoff revealed how diabolically difficult it is for regulators to protect the public in the twenty-first century.”

The market system is based on trust. As such, it is ever vulnerable to the abuse of trust. You cannot have a market, you cannot have investment – you cannot have capitalism – without trust. In fact, you cannot have trust without the inevitable abuse of trust. Make no mistake. The world is a dangerous place, and there are bad people in it. No matter how carefully we hedge our bets, it all boils down to trust.

One of the illusions fostered by government regulation is the idea that regulators can somehow “make” investments more trustworthy. “If the Madoff story proves nothing else,” writes Henriques, “it proves that regulators are living in a dream world, one that is very different from the dream world populated by investors.”

According to Henriques, good regulators “believe in skepticism” while “most investors crave simplicity.” Good regulators believe in “the fine print” while investors “never, ever read the fine print – never.” In Washington, according to Henriques, everyone was concentrating on regulations and fine print. In the real world, investors either trust the investment or they do not. All the fine print in the world, and all the king’s regulators, cannot protect you.

The full-disclosure investment regime has generated a lot of fine print, and many regulations. But, says Henriques, the regulatory protections aren’t worth much because they don’t “reflect the way today’s investors make their decisions.” Decade after decade Americans have enjoyed protection and prosperity. This enjoyment has been so long established, that protection seems assured. We assume that our investments are safe, that our pension funds are secure, that the government insures everyone, that the regulators have superhuman powers.

Our assumptions have been wrong and are based on America’s long prosperity. We have been safe for decades, and investment has been profitable. Such is not always the rule in history. As economist Vilfredo Pareto explained, a Roman penny invested at 4 percent per year around the time of Christ would today be worth more than the earth’s weight in gold. Therefore, as anyone can see, history has not been safe for investors. To prevent that Roman penny from ballooning into an absurd amount of wealth, there has been a lot of piracy, and a lot of plunder through the centuries. The number of trustworthy persons is counter-balanced by the crooks and criminals. The failure in the case of Madoff, says Henriques, was the investor’s failure “even to ask for some fine print, much less read it.”

Doesn’t common sense argue against putting your money in something you can’t understand? Doesn’t a high rate of return signal high risk? And what about putting all your eggs in one basket? As Henriques explains, “They failed to see that no one should hand all their money to anyone simply because they trust him, or because someone they admire trusts him.” And yet, adds Henriques, “that is what so many millions of people do. We do not consult the fine print to decide if we can trust someone. We consult our friends, our relatives, our coworkers … and, ultimately, our gut.”

And what is the I.Q. of your gut?

“More rules and more fine print aren’t going to do much to stop the next Bernie Madoff,” says Henriques. The world of regulation is a world of illusion – the promise of protection without the reality. For in reality, we are all responsible for ourselves; so there is no substitute for reading, for thinking, and for careful consideration. The question of trust is one that each investor must deal with. It is a question that requires intelligence, knowledge, effort and judgment.

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About JR Nyquist

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