Madoff Scandal Shows Need for Prudent Investing Principles

(MoneyWatch)  The news that Bernard Madoff was sentenced to 150 years was no doubt met with relief and joy (among other emotions) by the investors who lost millions in his Ponzi scheme. While it may be of no consolation to those caught in Madoff's web of lies, this tale serves as possibly the most extreme example of the importance of following prudent investing guidelines.

The importance of avoiding scams like this cannot be overstated. Consider some of the comments made by Madoff victims during the sentencing:

• "The fallout from having your entire life savings robbed from right under your nose is like nothing you can describe."
• "My life will never be the same. I am financially ruined and will worry every day about how I can take care of my wife."
• I was introduced to Bernard Madoff 21 years ago at a business meeting. I now view that day as perhaps the unluckiest day of my life."

The following are some of the important investing lessons highlighted by this tragic tale.

You must accept some risk in hopes of achieving higher expected returns. Madoff drew his victims in by "demonstrating" consistently high returns with seemingly little risk. That simply doesn't happen. The reason some investments have higher expected returns is because they entail risk. If there was no risk, there would be no risk premium, and the investments would earn the same as riskless Treasury bills.

Stick to investments properly regulated by the authorities. One of the reasons Madoff could get away with his scheme was because he was operating as a hedge fund, which is not regulated by the SEC. On the other hand, mutual funds are highly regulated by the SEC. (For more on the advantages of investing in publicly traded investment vehicles, see my post regarding how to tell if your money is safe.)

Perhaps the biggest lesson to take away from this terrible situation is also the most simple: When something appears too good to be true, it usually is.
If you drop an egg and a tennis ball off the table, the egg will shatter while the tennis ball will bounce back. Investors who made the mistake of investing with Madoff have seen their portfolios shattered like the egg, and once shattered, there is no recovering.

On the other hand, those who have suffered losses in their public equity holdings at least have the opportunity to see their asset values bounce back, like the tennis ball. And history suggests that if you have the discipline to stay the course, the odds greatly favor being rewarded for your patience.