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Why Are “Sophisticated Investors” So Dumb?

By JLP | December 15, 2008

I find it funny that nearly every time that I read a story in the Wall Street Journal about the collapse of a hedge fund or a story about fraud, the words “sophisticated investor” are used to describe those who were swindled or those who lost it all.

Is “sophisticated investor” the new term for “ignorant investor?”

The latest case involved outright fraud. This super-secretive investment advisor presided over the biggest Ponzi scheme ever. Estimates are that Bernard Madoff lost $50 BILLION of investor money. He was paying investment returns of approximately 1% per month to his current investors with money collected from new investors. This 1% monthly return was delivered consistently month in and month out, no matter what the market was doing. RED FLAG!

Why is it that those who are considered rich always think they have to use some sort of “sophisticated” investment strategy? What’s wrong with them using low cost index funds like the rest of us use?

My advice: the next time you hear an investment advisor say something like, “This is a rather sophisticated investment strategy…,” RUN FOR THE DOOR!

For more information on the Madoff Fraudster, see:

Financial World Still Amazed Over Madoff’s DownfallUSA Today

Banks Shrug Off MadoffForbes

Topics: Fraud | 11 Comments »


11 Responses to “Why Are “Sophisticated Investors” So Dumb?”

  1. Adam - Natural, Personal Finance Says:
    December 15th, 2008 at 11:35 am

    I believe they use “sophisticated” instead of “complicated” or “proprietary.” A key notion here is that when things are good, you want to be as hands off as possible. You wouldn’t manhandle the goose that lays the golden egg would you?

    Similarly, by not investigating things which are too good to be true, you allow yourself deniability in case things do go wrong. If you have to be part of a class action lawsuit, things will go smoother if you can say “your honor, I know nothing of investments except what I was advised and I was the victim here” vs “yes I know quite a bit about investing and I know this kind of performance was impossible and probably illegal, but I left my money there anyway.”

  2. Joe Says:
    December 15th, 2008 at 11:42 am

    I think it’s a great reminder of the old adage:

    “Invest in what you know!”

    If you don’t fully understand an investment, walk away. It’s worked well for Warren Buffet thus far ;-)

  3. Goalhunter Says:
    December 15th, 2008 at 2:44 pm

    Sophisticated investor is a legal term, not just pretend or presumtuous. Those who got involved probably had to sign a piece of paper that said they were sophistated enough to understand the opportunity.

    There are products that can only be sold to “sophisticated investors” and in those cases the sales people have to make sure they’re not selling them to the masses. If deals are sold only to “sophisticated” investors then there are lower regulatory requirements. For example, a formal public offering that could be sold to anyone is different from seeking private investors. No bank could market private investments in local restaurants to the masses even if it could sell. That’s because such an investment is not properly sterilized and presented for anyone but a “sophisticated investor”.

  4. JimmyDaGeek Says:
    December 15th, 2008 at 3:07 pm

    Remember Long-Term Capital Management (LTCM)? In 1998, it lost $4.6 billion in less than four months, and had to be rescued by the Treasury Department using Wall Street firms to put up money. The rocket scientists there guessed wrong in a big way.

    Look at Bill Miller of Legg Mason value Fund. I recently read that he bet wrong by moving into the supposed safety of Fannie Mae and Freddie Mac before they collapsed.

    Some people are saying the Buffett has also made some bad mistakes lately, but time will truly tell.

    In short, sophisticated does not mean dumb. When they lose, it’s because their luck runs out.

    I believe that Madoff’s story will show that he bet big, lost big and wasn’t able to recoup his losses. To keep from being found out and having to admit to his admirers that he lost their money, he maintained his facade. This won’t excuse the outright theft from later investors, but may explain what happened.

  5. Craig Says:
    December 15th, 2008 at 3:21 pm

    I agree, I want to get into investing and research more info. I want to look for advice, but where do I go? These “experts” who are supposed to know everything, are wrong and can’t be proactive, so what chance do I stand?

  6. Roland Manarin Says:
    December 15th, 2008 at 3:52 pm

    Malinvestment. Plus greed/fear.

  7. Rick Francis Says:
    December 15th, 2008 at 3:53 pm

    I think the problem is that Investing is just different from most other areas of life. For example, in almost any other industry you can pay more to get better goods or services. In investing paying more fees often results in worse performance. In any other field more experience correlates with better results. In investing a novice can buy low fee index funds and get the average market return with little effort. However, most professional fund managers pour a huge amount of effort into research yet fail to beat the indices in any given year.
    Craig, if you are willing to accept market returns then you can make a portfolio using low fee index funds. If you don’t feel confident doing it yourself hire a fee only financial advisor to help you. The key is that their only source of income should be the fee you pay them for their time. The last thing you want is someone that has a conflict of interest where they try to sell you financial products that make them large commissions. Be VERY wary of anyone selling anything to you- especially annuities, whole life insurance or managed mutual funds as those have large fees.

    -Rick Francis

  8. Lord Says:
    December 15th, 2008 at 5:56 pm

    That is because the principal criteria for ‘sophisticated investor’ is having more money than you know what to do with. I trust it is better off in the hands of others then, permanently. He was doing the rest of society a favor.

  9. poor boomer Says:
    December 16th, 2008 at 10:26 am

    Re: “Sophisticated investor is a legal term, not just pretend or presumtuous.”

    I think the applicable legal term here is “accredited investor” per SEC.

    Perhaps being deemed an accredited investor appeals to their vanity and elitism. After all, accredited investors are members of an exclusive club, and investments restricted to accredited investors are definitely not for the masses.

  10. Tim Says:
    December 16th, 2008 at 3:30 pm

    it’s greed, plain and simple. greed makes us ignore or wish away things we don’t want to know or believe is true. people believed in madoff, not the investment. this is what happens when due diligence isn’t done. sorry, i have no sympathies for any of them, even the charities and individuals who lost their life savings. they were lured by word of mouth gains and disproportionate gains. they sure weren’t looking for sympathy when they were raking in the investment cash.

  11. Joe Says:
    December 23rd, 2008 at 4:44 pm

    “Sophisticated investor” means: smart enough to get hoodwinked.

    If you keep to the basics, you will be too ‘basic’ to be a mark for the scammer.

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