I am not a huge TV junkie, but I did catch The Good Wife the other night. The plot was especially interesting to me in that an investment adviser had been murdered because of a Ponzi scheme and for defrauding hundreds of investors out of their money. Sounds familiar? Sure, we all remember the notorious Bernie Madoff’s Ponzi scheme that rocked Wall Street and the investment world. I doubt that we will forget it anytime soon (no thanks to the media). But our memory of the event leaves us with lessons.
Lessons Learned From Past Investment Scams
One lesson learned: investors will be more prudent when working with investment advisers and will follow proper due diligence. But one of the tougher consequences here is the overt mistrust of Wall Street firms, banks, and the financial industry as a whole. That hurts everyone –- from the economy in general, to you and me, and the thousands of investors who decide to trust no one and do nothing (it wouldn’t be so bad if they instead invested with online stock brokerages on their own, but that’s not often the case).
With the near-collapse of the financial industry, a recession, and the bailout of many large firms still paying extraordinary bonuses, a huge Ponzi scheme proved to be the last straw. The average investor was confused before this happened, now it’s become worse. Bad lawyer jokes have now been replaced by banker jokes. So, whom do we trust?
You see, I do not buy into the contention that no one can be trusted and the average investor can’t tell the difference. The truth is that the overwhelming majority of advisers happens to be ethical and the investment industry is one of the most regulated industries in the world (yes, despite the SEC’s failure to act in the Madoff case). What struck me though, is that it’s not merely one demographic that is more inclined to be fooled. Many affluent folks duped by Madoff proved to be as susceptible as the rest of us.
Bernie Madoff seemed to have it all. He had a lot going for him as one erstwhile Nasdaq Stock Market Chairman, former head of the Securities Industry Association’s trading committee and active philanthropist. His family was well known in high society. He was also a registered investment adviser (RIA) regulated by the SEC. So, he was not some chump in a cubicle calling you at dinner time to get into the next “hot” stock. He had vast industry experience, credentials, and relationships to back him. How can you not trust someone with this type of pedigree and reputation?
How To Spot A “Madoff” & Avoid Investment Fraud
Surely hindsight is 20/20, but should investors have looked a little farther behind the curtain, they may have seen some red flags. And if you look at some of these things, you should be able to spot a potential scam going forward. So, what are some of the questionable things that Madoff did that could be warning signs to watch out for?
#1 He made a big deal about his reputation. Sure, we all want and expect our advisers to be honest and ethical. But those who go out of their way to brag of this should be viewed with suspicion. This is often a red flag. Yes, tell me your Code of Ethics, etc. but more than that, who are you trying to convince with overboard bragging of your ethical standards –- us or yourself? The same goes for religious affiliations. I had a discussion with the Director of the Securities Division in Arizona last year and he indicated that a majority of fraud cases involve religious organization and their constituents, or are directed at these organizations. Wow! While Madoff didn’t directly do this (though a lot of his fellow Jews were affected), he did tout on his website,
“Clients know that Bernard Madoff has a personal interest in maintaining the unblemished record of value, fair dealing and high ethical standards that has always been the firm’s hallmark.”
#2 He did not use a custodian. Any financial adviser you work with should have a third-party custodian that actually holds and clears your money. You should never make investment checks directly payable to your adviser or their firm. Instead, you should make them payable to the firm’s custodian such as Schwab, Scottrade, TD Ameritrade, Trust Company of America, etc. That way, your adviser doesn’t directly control your accounts or your assets. Most good advisers will have this system in place. Beware of the ones who do not. In the same regard, statements should be coming from a third-party, not from your adviser. It’s fine if your adviser sends quarterly performance and/or tax reports, but statements should be coming from the custodian. Make sure a third-party acts as a “firewall”. Madoff didn’t do any of this. He formed limited partnerships and hedge funds. And he generated his own statements.
#3 He offered exceptional returns. Not only does this go against SEC rules, but no one can promise a rate of return unless it’s a fixed asset. And fixed assets will not have very high rates of return. Madoff was promoting and promising consistent monthly returns of 1%. Anyone who suggests or promises such consistently high returns should be avoided. Any good financial adviser knows that no one has a crystal ball, and high returns on a consistent basis are impossible.
#4 He leveraged outlandish testimonials. Here’s where it gets dicey for investors who go with a messianic investment professional. Bernie Madoff was all about the word of mouth recommendation. And we all know how well “word of mouth” sells. Imagine this: he belonged to a bunch of country clubs which would boast Madoff’s services as a benefit to members. The exclusive nature of country clubs adds a lot of credibility to Madoff’s enterprise. If so many illustrious people are investing with Madoff, then how can you go wrong, right? Again, another example of “herd mentality”. Now registered investment advisers are not permitted to use testimonials for a reason. A referral is fine, but just be cautious of hype related to one individual –- especially when these other problems listed here exist.
#5 He was not transparent. Finally, there was that air of mystery with Madoff — he would not or could not easily discuss his investments with his own clients. Unfortunately, many passive investors have the attitude that they’d rather not know the details, and that they’d rather leave it all to the pros. But this is exactly the kind of attitude that will lead you into trouble — you are ultimately responsible for your money so it’s mighty important to keep up with how it’s doing. Sure, you will not understand every nuance your adviser explains to you in detail and that’s why you hired him or her in the first place. But any investment strategy that is very unclear, confusing, and sounds too good to be true probably is. In such cases, run as far as you can from this type of investment (and accompanying adviser).
In the world of investing, there will always be the proverbial bad apples out there. Madoff’s case is discouraging to say the least. Just make sure you do your homework and understand how your adviser operates, the strategies he / she employs, and what he / she is really offering so you can avoid being the next victim.
Become less vulnerable to scams by doing your own investing or learning about investing as much as you can. Make sure you start slowly and tread carefully before getting into any form of stock and options trading.
Contributing Writer: Todd Smith, CFP
Copyright © 2010 The Digerati Life. All Rights Reserved.
{ 8 comments… read them below or add one }
But any investment strategy that is very unclear, confusing, and sounds too good to be true probably is
This describes Buy-and-Hold. Buy-and-Holders get upset with me when I say that. But it really is so and it needs to be said.
Where did the money come from when stock prices were going up 20 percent and 30 percent per year in the late 1990s? It was being borrowed from future investors, who are now today’s investors — Us! We borrowed $12 trillion from our future selves in the late 1990s by practicing Buy-and-Hold Investing. That’s why we are all busted today. It’s a heavy debt to have to pay off.
Humans are social creatures. We all get it now that the Madoff fund was a ripoff. We don’t get it that Buy-and-Hold is a ripoff because we don’t hear enough other people saying it yet. The evidence was always there, just as it was always there with Madoff. But we don’t see evidence until others see it. That’s just the way we are built.
I think the answer lies in developing a different sort of emotional approach to investing. Most of us discourage questioning of our investing views; we feel uncomfortable when our strategies are questioned. I think we need to encourage questioning. It is not possible to have true confidence in a strategy that has not been questioned. Exposing our ideas to questioning is how we learn about the flaws in them.
We will never be able to discover these flaws by ourselves. We need to hear what others (those who have not bought into our ideas) have to say. We need to think of investing analysis as more of a community endeavor and not as something we do sitting alone in a room thinking grand thoughts.
Rob
Nice breakdown, but I really think it all comes down to this:
“Anyone who suggests or promises such consistently high returns should be avoided.”
If it seems to good to be true, it probably is. Sadly his victims learned a hard lesson that there is no surefire quick and easy way to make money. Greed and impatience have an awful lot to do with the whole financial debacle of which Madoff was emblematic.
I agree that the majority of advisors probably are ethical and honest, but in the end, you can’t be completely sure. I think your point number two is the most critical. If a third party custodian had been used, Madoff wouldn’t have access to write checks as he pleased.
That’s a great list of red flags.
While Madoff’s clients were very rich, these types of scams can be perpetrated against anyone. In addition to keeping in mind those red flags, you can avoid getting caught up in an investment scam by having realistic expectations for your investments. Scammers prey on people looking for extraordinary returns. If you look for good, solid investments, you won’t fall for their tricks.
Rob’s comment in relation to Madoff is an interesting twist. First, regarding Madoff, I think the guy was a marketing genius. In todays world, it is amazing what how easily you can pass yourself off as an expert. A close friend of mine owned a credit card website where he supposedly rated cards. It was sold for north of $10 million several years ago. He is considered an “expert” in the credit card industry and is always giving sound bites for various articles now. Its a joke – he is no more an expert than I am a brain surgeon. However, he is a master at marketing himself, and for that I commend him.
As for buy and hold – I agree with Rob, its outdated. The stock market is not longer a vehicle to pump money in monthy and expect to earn 10% a year. Look at your portfolio from 2000 to 2010 and tell me if you have made a lot of progress there?
The Madhoff scandal is just is a high-profile example of a much bigger problem. Although most financial advisors are honest, there are still many advisors who are either dishonest or incompetent. And, customers lose their life savings every day to these advisors. Here are the two main problems in my opinion:
1. Financial advisors aren’t regulated effectively. Yes, they are highly regulated, but it’s not effective. The SEC and FINRA are slow to act against dishonest financial advisors and they rarely catch fraud on their own. This is especially true at the early stages when some customer’s deposits could still be recovered.
Solution: Financial advisors should be bonded. They should also be required to use a custodian or submit to independent annual audits. This isn’t too burdensome for the advisor and it would effectively protect customer deposits.
2) There is a conflict of interest in the financial services industry. Advisors are often paid the highest comissions on the lowest yielding investments. If they want to do the right thing for their customers, they make less money. Customers often get stuck with investments they shouldn’t be owning, especially near retirement.
Solution: Use a fee-based financial advisor or pick your own investments.
You should be able to track your reported investment returns relative to the returns observable in the market for a similar class of investments. For example, if your funds are being invested in value stocks.
Probably the following tips helps to avoid investment fraud:
– Ask around and get referrals from people you know and trust.
– Get to know your adviser and don’t blindly trust him, ask lots of questions.
– Check his credentials whether your broker is a Certified Financial Planner (CFP) professional or not.
– Never pay the money directly to your advisor. Make your payment directly to the investment firm or the fund itself.
Thanks for sharing……