How would someone have avoided being snared by Madoff? There were many very successful businesspeople on his list of victims. They liked the fact that Madoff appeared conservative none of this "up 60% one year and down 25% the next." These people were not risk seeking. Interestingly, there were no financial pros on the list because the first thing those folks want to know is "how are you doing this?" and of course they were offered no answers they liked.
But still did you have to be a Wall St guru to know this was a scam? For one thing you could have looked at the incentives and conflicts of interests, allegedly such as those feeder funds that had 100% of their funds with Madoff but we are told did not do due diligence. The dangers of mixed incentives are nicely summed up by the great Jason Zweig wrt Mutual Funds
Is Your Fund Pawning Shares at Your Expense and in this Forbes piece
"Don't Take Financial Advice from Salespeople"
Imagine seeking medical attention at a clinic owned by a pharmaceutical company. A doctor treats your backache, but also prescribes the company's most expensive drugs for restless leg syndrome, social anxiety and erectile dysfunction.
Got more than you bargained for?
In the world of investing, too, Americans often get more than they need or want. At large private banks, "financial advisers" claim to play the role of impartial advice-givers, but in reality often act like salespeople. As a result, too many people are now facing massive losses on their personal savings and investments.
In fact, only 8% of financial advisers arrange for fee-based compensation with their clients, according to an annual compensation report by Registered Rep., a magazine for investment professionals. The remaining 92% are paid primarily by commission.
In other words, advisers tend to make more money when they sell the expensive products or services their banks offer.
Much like patients who don't understand the intricacies of the medical profession, financial clients accept this conflict of interest largely because they don't fully understand how the investment industry works.
...
The staggering case of Bernard Madoff's $50 billion fraud was an even more potent example--illustrating the conflicts of interest that arise when the roles of asset manager and custodian aren't clearly delineated.
Typically a custodian bank serves as a middleman, authorized to make trades on behalf of its clients based on orders from the asset manager. The custodian thus acts as an independent third party, helping to safeguard assets. Madoff's investment advisory firm, however, did not use an independent custodian, and Madoff's clients sent their money directly to him.
What better way to cover up investment fraud than to eliminate the checks and balances?
Investors paid no heed to this inherent conflict, lured by Madoff's supposed high returns. After all, he was not the only investment manager doubling as custodian. Shockingly, it is legal for a money manager to also hold custody of assets as long as it is disclosed.
While UBS and Madoff were one-off cases, a more pervasive conflict of interest is the coupling of investment advisory and asset management services.
At most major banks, private bankers dishing investment advice are offered cash incentives to sell funds managed by their firm. Even more insidious is when they claim to have "open architecture" or sell funds on their "third-party platform." This simply means their firm has negotiated a fee-sharing arrangement with an outside fund manager. So they have a financial incentive to steer investors into that fund.
In the investment industry today, most private banks play all three roles: investment adviser, asset manager and broker-dealer. Regardless of the conflicts of interest inherent in this setup, U.S. financial regulations simply require a series of disclosures on the last page of the pitch book. In practice, this does very little to safeguard investors. Indeed, it's akin to the FDA allowing pharmaceutical sales reps to write prescriptions, as long as the treatment comes with a few pages of fine print.
This problem won't be solved with more red-tape disclosure requirements, which ordinary investors don't read anyway. Instead, regulators must shift their focus to addressing the fundamental problem of the financial industry--conflicts of interest. Until they do, many financial advisers will continue to prescribe the wrong medicine. And investors will suffer.
Ross Anderson's "Security Engineering" presents a Security Engineering Analysis Framework that includes the things security folks have dealt with for their whole careers - the policy of what is supposed to happen, the security mechanisms that deliver on the policy, and the assurance that builds up confidence that the policy and implementation are in alignment. But he adds one new factor into the traditional information security mix that explains many things that happen in the real world - incentives
Information security in the real world is nowhere near as simple as defining a policy, then building a mechanism and conducting assurance. For one thing each of these activities by themselves can be a large slice of effort, doing them in concert is more difficult still. In other words for all this to work we need an external driver called incentives. Why are IBM, Oracle and Sun able to sell Identity Management suites for millions of dollars? The technology is not complicated, but they know they are selling to compliance which has a very high incentive to check off that particular check box.