Everyone knows about Bernie Madoff’s Ponzi scheme and how he defrauded his victims of $65 billion by exploiting their trust. You’ve probably told yourself, “I never would have fallen for that.” But are you sure?
We all want the highest possible returns with the smallest possible risk, which is exactly what Ponzi schemes promise. And Madoff had a great reputation for achieving consistently positive results for his clients—seemingly for many years, in some cases. Further, he ran what appeared to be a legitimate company and was a Nasdaq chairman whose expertise was recognized by the SEC and Congress.
Yet his victims included financial industry professionals, a group that should have been able to spot the warning signs. It wasn’t until the Great Recession hit, and investors wanted to withdraw $7 billion from Madoff’s “fund,” that the scheme collapsed.
When smart people are caught, what hope is there for the rest of us to avoid getting scammed? Here are some tips for sussing out investment fraud.
Choose Widely Available Investments
Don’t participate in “investment opportunities” that spread by word of mouth—one of the tactics Madoff used. The National Endowment for Financial Education warns that this kind of “affinity fraud,” where scammers prey on members and even leaders of groups in which people trust and respect one another, is one of the most common investment scams.
If your church friend tells you about an investment club where he’s earning great returns and you have to be invited to join, steer clear. Put your money in broad-based, well-known, low-cost, easily tradeable investments, such as S&P 500 exchange-traded funds and mutual funds.
Financial advisors can attach any of more than 100 professional credentials to their names. The most meaningful ones require years of study and experience to attain, adherence to a code of ethics, and continuing professional education.
Top-notch credentials include the Certified Financial Planner (CFP®), Chartered Financial Analyst (CFA), Personal Financial Specialist (PFS) and Chartered Financial Consultant (ChFC). An advisor whose credentials are too easy to attain is either poorly qualified or out to scam people. Check out this database of financial credentials, maintained by the Financial Industry Regulatory Authority, or FINRA, to see what’s required to earn them.
Yes, someone can hold a time-honored credential and still rip you off. It might be that no one has detected their scam yet. But making sure so-called “professionals” aren’t promoting their services with a credential they earned in four hours will easily root out at least the lazy bad actors.
Conduct Background Research
Investment advisors are regulated by the Securities and Exchange Commission (SEC), FINRA and state securities agencies. Check with each agency to verify an advisor’s employment history and licenses—and to check for complaints and disciplinary actions.
FINRA’s BrokerCheck tool tells you whether an individual or firm is registered to sell securities, offer investment advice or both (registration is mandatory).
The SEC’s Investment Adviser Public Disclosure website lets consumers check an investment advisor’s registration status, professional background and conduct. It also shows you the advisor’s form ADV, which provides more information about their business activities.
Google your state plus “securities regulator” to find state-level information on insurance agents and on investment advisors who aren’t required to register with the SEC (those who manage less than $100 million in assets).
Advisors may be regulated by more than one entity, so check all three sources to get the most complete picture of their background.
Again, brokers and advisors can have spotless histories and still be ripping people off if they haven’t been caught. But at least you can avoid working with someone who’s already a known problem.
Perform Your Own Due Diligence
Even if you’re working with a financial professional you have every reason to trust because they have impeccable credentials and no disciplinary actions, you need to understand how they’re going to employ your capital.
Ask lots of questions of your advisor, but then do your own research from well-informed, independent sources that don’t stand to gain anything from your investment choices, such as authoritative investment books and online publications. Morningstar.com, for example, is one of the most reputable sources of information on investment performance. One sign that made some potential investors leery of Madoff, for example, was that his returns were unusually consistent, even for what appeared to be a relatively conservative fund.
It’s not just the greedy, the elderly, the cognitively impaired and the ignorant who fall for investment scams. Many victims are confident, well-educated, experienced investors. Scammers are trained to take advantage of your unique weaknesses. Don’t assume that investment fraud only happens to other people. Do your homework on financial advisors’ backgrounds and the investments they want you to buy, and you’re much less likely to get taken advantage of.