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 Bad lawyer jokes have now been replaced by banker jokes.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
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