Stories about fraudulent investment firms keep popping up like whack-a-moles at an amusement park. While we could hope that all the media attention and new financial regulations will keep investors safe, everyone still needs to do their own due diligence.
What are some of the best ways to avoid financial fraud? In his book How to Smell a Rat, Forbes columnist Ken Fisher points out four flags that your investment advisor may be more interested in your purse than your portfolio:
1) Custody: In most situations, you can avoid outright financial fraud by keeping your money manager separate from your custodian. By holding your assets in your own personal investment account (with your name on it) at a large custodial institution (such as Charles Schwab, Fidelity, or Ameritrade), your advisor won’t have access to your funds for anything but ongoing management fees.
How do you know if your advisor has custody? Here is great tip – this is readily available public information and can be found in your advisor’s SEC Form ADV. Be sure to read Item 9, which covers custody practices. You can easily search for your advisor and review this important document at the SEC’s website.
Similarly, fraud can be avoided by not depositing funds directly with your financial advisor and by making sure that you have 24/7 access to your account online, through a third-party website.
2) Amazingly Exceptional and Stable Returns: Performance numbers that are too good to be real are a big red flag. Almost all financial advisors have bad years, and admitting to a period of underperformance is perfectly normal and a sign of honesty.
Interestingly enough, many fraudsters bring in naïve investors not by having high annual gains, but by boasting seeming immunity to market fluctuations. One Madoff fund boasted annual returns of “only” 11%, but never posted an annual loss during its seventeen-year history. Allen Stanford perpetrated a $7 billion fraud largely based on his company’s certificates of deposit – an investment usually reserved for small and conservative investors.
3) Incomprehensible Strategies: A simple approach is to follow Peter Lynch’s advice and invest in companies that you know. Or, at the very least, invest in strategies that you can understand. Be wary of advisors that speak about the sophistication of their “black box” strategies and “quantitative methods” without offering a clear explanation of the basics.
4) Bothersome Bling: Great investment managers sometimes have dull hobbies. If they are excessively distracted by their polo ponies, or hobnobbing with the rich and famous, chances are that they are not paying attention to your portfolio.
These tips won’t necessarily protect you from investment losses or bad advice, but they can go a long way towards giving you a sense of comfort and security from potential fraud. Remember that there is no such thing as a “sure thing” and that high investment returns often signify higher levels of risk.