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Three Risks

Adam M. Grossman

ON DEC. 17, 2002, Harry Markopolos walked out of his Boston office wearing an oversized trench coat and a pair of white cotton gloves. His destination: the John F. Kennedy Presidential Library. 

A quiet figure, Markopolos worked as the chief investment officer at a small firm that specialized in trading stock options. He had heard about a New York-based competitor that was apparently doing similar work, but with much greater success. Following his boss’s recommendation, Markopolos tried one day to replicate his competitor’s strategy. But when he did, a funny thing happened. He realized that he couldn’t—not because he wasn’t capable, but because it simply wasn’t possible.

As Markopolos tells the story, it was just five minutes before he began to suspect something fishy about the New York firm’s numbers. By the end of day, with just a little more work, he was sure of it. So sure, in fact, that Markopolos decided to alert the authorities.

Markopolos prepared a detailed written report. His objective that December day: to hand deliver it, anonymously, to the New York State Attorney General, who happened to be speaking at the Kennedy Library.

Markopolos’s analysis was dense, packed with math. But the bottom line was clear: It was mathematically impossible for the New York firm to be doing what it claimed to be doing. If that was the case, the only alternative was that the firm—Bernard L. Madoff Investment Securities—was a giant fraud, running the world’s largest Ponzi scheme.

In Markopolos’s words, he “gift wrapped” the Madoff case for the government. In addition to the New York Attorney General, Markopolos also contacted the SEC. Yet none of these regulators took any action. Madoff was able to continue his fraud for another six years before it finally unraveled.

Markopolos was recently in the news again—this time with fraud accusations against General Electric. On a newly launched website, Markopolos argues that, “GE Is Headed Toward Bankruptcy.”

Economist Elroy Dimson once defined risk this way: “More things can happen than will happen.” The world is an uncertain place. Some things are easy to predict, but most aren’t. Sometimes, there are warning signs—such as Markopolos’s repeated attempts to get regulators’ attention. But sometimes—maybe most of the time—there are no warning signs at all.

Moreover, even when there are signs, they’re never easy to interpret. Consider GE. When Markopolos published his report, the stock dropped more than 10%. But the next day, it made up most of that lost ground. What should we make of that? Are we ignoring Markopolos again at our peril? Or is it possible that he’s wrong this time? The investment world can be a confusing place—and often only makes sense when we look back months or even years later.

So how can you protect yourself? Financial risk, in my view, fits into three categories. If you’re feeling rattled by recent events, I’d recommend taking your portfolio and “auditing” it for all three risks:

1. Overall market risk. Since 1997, the U.S. stock market has doubled in value twice, quadrupled in value once and gotten cut in half twice. Where it goes next, no one can say. Fortunately, the solution to this risk is relatively easy: appropriate asset allocation.

2. Individual investment risk. Sometimes, you can spot a risky investment from a mile away, but it’s rarely that easy. Investments are more like Rorschach tests. For any given investment, you could highlight the risks or you could highlight the opportunities, depending on whether you’re predisposed to like the investment or not.

Consider Tesla. Its CEO is a genius, often compared to Thomas Edison. But he’s also demonstrated erratic behavior and been in trouble with regulators.

Sometimes, new risks materialize out of the blue, as they did with GE. Fortunately, the solution to this risk is also straightforward: diversification. Keep your bets small so you can’t lose too much the next time Harry Markopolos puts on his trench coat and white gloves.

3. Fraud risk. The last category of risk might seem like the hardest to protect against. But in my view, it’s the easiest. For the bulk of your investments, avoid anything that looks esoteric and steer clear of private investment funds. Invest only in things that are straightforward and that have publicly listed, easily ascertained prices. And be sure your assets are held by a large, well-known custodian—a firm like Fidelity Investments or Charles Schwab. This was the huge red flag with Madoff—and you didn’t need a degree in advanced mathematics to see it.

Adam M. Grossman’s previous articles include Room to DisagreeNever Mind and Double Checking. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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Langston Holland
Langston Holland
2 years ago

I always love your articles. 🙂

One thing that fascinated me in school was the revelation that investment risk is not the risk of loss as most people think; it’s risk that your return will vary about the mean. Thus you can have two investors that end up making the same return while experiencing very different levels of risk. One guy rides a rollercoaster while the other has a smoother journey. Both arrived at the same place, but the first guy looks like he went through a war, while the other is rested. That’s the math.

It’s a beautiful thing that we can effectively eliminate individual company risk so easily these days with overall market (index) funds. On several occasions I’ve read about a company going under that I had shares in through an index fund and smiled as my fund didn’t seem to notice. Then again, my fund only moderately noticed those 4% of stocks that provide almost all of the market’s gains. Minimizing individual company risk cuts both ways.

Then we exit the math and come to fraud. This reminds me of getting robbed in a back alley. The thing I’d ask is why people choose to walk there in the first place. Stay out in the light where things are clear and understandable.

kt2062
kt2062
2 years ago

When I bought GE stocks in 2008 it seemed like a trusted company that was sure to come back. I only have three individual stocks but GE was my biggest investment among the three. It did go back up initially but then it plummeted. Now there’s the Markopolos thing.
Any advice on how to go forward with stocks like this?

Jonathan Clements
Jonathan Clements
2 years ago
Reply to  kt2062

You don’t know how GE shares will perform going forward, so you need to make the decision based on other factors. Two immediately come to mind: 1) risk — favoring funds over individual stocks will reduce your portfolio’s risk; and 2) tax savings — selling, I’m guessing, would give you a tax loss to offset against other gains and up to $3,000 in ordinary income, assuming the stock is held in a taxable account.

kt2062
kt2062
2 years ago

The following is taken from the GE Whistleblower Report from the above Markopolos website:

Potential for Compensation
Prior to the initial distribution of this Report on August 15, 2019, the Company entered into an agreement with a third-party entity to review an advanced copy of the Report in exchange for later-provided compensation. That compensation is based on a percentage of the profits resulting from the third-party entity’s positions in the securities, derivatives, and other financial instruments of, and/or relating to, General Electric Company (“GE”) (NYSE: GE). Those positions taken by the third-party entity are designed to generate profits should the price of GE securities decrease.

Prior to the initial distribution of this Report on August 15, 2019, the Company also submitted this Report to the U.S. Securities and Exchange Commission’s Whistleblower Program and the U.S. Department of Justice’s FIRREA Whistleblower Program. Both or either of those submissions may generate profits for the Company independent of the financial performance of GE and/or the securities, derivatives, and other financial instruments of, and/or relating to, GE.

Lastly, members of the Company are personally in possession of securities, derivatives, and/or other financial instruments of, and/or relating to, GE, which may generate profits should the price of GE securities decrease.

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