Another major point is to “be afraid, be very afraid” when the investment performance seems to ignore the underlying markets’ volatility – unless you’re a fixed-income fund not pricing-to-market and 100% of your holdings avoid default, the “45-degree angle” performance line set by Bernie Madoff is too good and NOT true. Even conservative, un-leveraged investors are bound to see ups and downs, however “dampened” they might be.

Finally, we’d highlight the “simplicity” criterion: “anyone who truly understands their craft should be able to explain their strategy in layman’s terms on a single sheet of paper”. Paraphrasing Pascal, Mark Twain or neither one, depending on who you believe said the original sentence, “I didn’t have skills/knowledge to write a short and simple investment case, so I’ve written a long/complicated one instead.”

Original quote: “I didn’t have time to write a short letter, so I’ve written a long one instead.”

LINKS:

Fraud detection: Red flags – a KnowledgeLeader “checklist” of sorts that is just that – a list of useful tell-tale signals or warning signs. As we said above, it shouldn’t be taken too seriously.

No one would listen – A Buysiders.com post about Bernie Madoff, whistle-blowers and red flags that remained ignored for way too much time. By the way, we’d now add another book suggestion to the ones we make in this post: The Confidence Game, recording Bill Ackman’s saga against MBIA Corp.

Essentials of Corporate Fraud – We’re not singling out this book as a leading publication on the subject, it’s just a way to open up “related book” searches. There are many many textbooks on fraud, forensics accounting and so on, and this didn’t necessarily save people from Enron, Worldcom, Madoff, etc. – and won’t necessarily prevent the next, big, “unimaginable” fraud either.

US agencies’ fraud-detection effors – As this Federal Trade Comission page shows and other pages not mentioned here corroborate, the US government is very concerned with fraud and tries to increase awareness of the issue. This handbook about the Red Flags Rule for protecting consumers’ IDs is an interesting read.

There’s lots of interesting content in Amazon.com’s launch page for “No One Would Listen”, the book by Harry Markopolos – the main whistleblower in the Bernie Madoff saga. The timeline in particular is very impressive: it shows that all in all it took ten years to uncover the mess – nine since the first contact with the SEC – by which time the problem was irreversible. And that’s far from the only case, which begs a question…

Apart from the “I want/ need to believe”-type mental traps that individuals fall into, how do we justify still having institutions supposed to keep watch so unready and unwilling to investigate red flags? Lack of funding, qualified personnel, IT infrastructure… they all seem like weak arguments even put together.

We won’t go into the Taleb argument that one must be highly skeptical of “results”, and let’s not recall the Bob Rubin “focus on processes, not outcomes” (great) advice. Let’s just highlight two other books on fraud or lack of oversight – one caught, one still perhaps on the loose.

The most Madoff-like story is David Einhorn’s Fooling Some of The People All of The Time, about his years-long struggle with Allied Capital. Again, the pattern of ignored warnings is troubling, and while the story eventually played out to Mr. Einhorn’s thesis (see the 5-yr chart here), it wasn’t due to regulatory action – the credit crisis almost did the company in.

The other book is a quick read – Barry Minkow’s Cleaning Up – about ZZZZ Best, the company he founded and took public as one of the youngest persons ever to do that (remember that this is quite pre-dot.com days!). Nice story, if it wasn’t all a Ponzi scheme, and one that also took a while to uncover. Since this account is in first person and Mr. Minkow later helped the FBI uncover several corporate frauds, it’s pretty interesting lore. We’ve watched the guy live in the first Value Investing Congress and he’s a decent speaker as well.

UPDATE (March 19th, 2010): Nice and funny video interview with Mr. Markopolos on Jon Stewart’s Daily Show.