The lessons of Bernie

The Madoff Ponzi scheme has shocked investors but offers many lessons. The first is that no one can rely on the Securities and Exchange Commission to spot all, or even most, of the bad guys in the financial system before they hurt people.

The SEC, in its current form, is not capable of preventing financial crime.

This is not to say the performance of the SEC cannot be im-proved. In fact, it must be improved. SEC officials were tipped off to evidence that Bernard Madoff’s investment operation was not legitimate. They ignored the evidence. The cause of this failure must be examined.

This, after all, is merely the latest in a series of frauds and illegal practices the SEC has failed to detect and act on until the frauds collapsed, in-cluding the implosions of Enron Corp. of Houston and WorldCom Inc. of Clinton, Mass.

Why all the failures? Is this because SEC investigators are overwhelmed? Is it because some SEC officials hope to pursue careers in the financial sector later and do not want to offend those who might be in a position to hire them? Is it because the officials face no significant penalty for failing to spot and pursue fraud?

In the Madoff case, is it because of his close ties to the SEC through his position on SEC advisory committees?

The causes of these SEC failures must be determined, and the agency’s performance must be greatly improved. Its decade of failures has harmed confidence in the U.S. markets among U.S. investors and international investors alike.

In the meantime, financial advisers and investors must exercise more caution in their investment of client assets.

The Madoff fraud shows that advisers cannot rely on third parties assembling funds of funds to perform adequate due diligence. They must thoroughly examine the due-diligence practices of fund-of-funds advisers and remember that these advisers have conflicts of interest: They are being paid to bring clients into the funds. The same lesson applies to hedge funds.

In short, advisers must do their own due diligence research on those who claim to be doing due diligence on managers.

Yet another lesson from the Madoff disaster is that if you don’t understand how the results have been achieved, don’t invest. Don’t buy a black box. Apparently, none of those who put money into the Madoff fund understood how he was producing the consistently good results he reported, yet they invested anyway.

If managers can’t or won’t fully explain their process, be warned and don’t invest.

Likewise, if the results seem to be too good to be true, they almost certainly are. Be skeptical.

Except in one or two instances, Madoff’s surprisingly consistent results apparently raised few questions among consultants or clients.

Another lesson: Diversify not only your portfolios but also the managers of those portfolios.

Many of Madoff’s clients reportedly had all or large parts of their total assets invested with his fund. Proper diversification would have saved these investors great financial pain.

Finally, be skeptical of advice or recommendations from colleagues or friends. This goes for both advisers and clients. Many of Mr. Madoff’s clients were led into the fraud by the recommendations of friends. No doubt this caused many to lower their guard, to their ultimate regret.

These lessons came too late for many wealthy and no-so-wealthy investors and institutions, but they could save many others in the future — if they are heeded.