In 2020, investors lost an estimated $47 billion to various investment scams, representing a sharp spike over the previous year. And it’s only getting worse, as fraudsters prey on people’s COVID-19 challenges and concerns, along with fears of missing out on the cryptocurrency craze. A larger portfolio and higher net worth may increase the risk that you’ll be the target of an investment scam. Lessons learned from one of the biggest investment Ponzi schemes of all times demonstrate why you need to be on guard—and how three key questions can reduce your risk of falling victim to an unethical money manager.
Why You May Be a Prime Target for Investment Scams
Financial advisory firms like Team Hewins receive calls every week from money managers asking us to recommend certain investments to our clients. Before we consider any new investment opportunity, we conduct extensive due diligence—reviewing regulatory disclosures, investment strategy, and performance results and ensuring that we see no risk of unscrupulous practices. Professional financial advisors have the resources and defense systems to guard against scammers…which is why they typically circumvent us and approach investors directly instead. Even with an advisor in place, however, the client should never hesitate to ask questions. Unfortunately, Madoff was able to fool many investment professionals as well as end clients. On your own it would be difficult to engage in the rigorous due diligence needed to flush out a scammer and protect the portfolio you’ve worked hard to build up. Fraudsters know this. AND they can easily obtain a list of high-net-worth individuals with accurate contact information. That’s why you may be a prime target for investment fraud—and why it’s vital to know what to look out for if you’re approached with an opportunity.
What We Can Learn from the Madoff Clues
On December 11, 2008, Bernie Madoff was arrested for committing what is arguably the largest investment scam in history, defrauding investors to the tune of $50 billion. Most victims were high-net-worth individuals, some of whom even consulted with their professional advisors before turning over huge sums of money for Madoff to manage. Why was Madoff so successful in swindling so many wealthy people? A look at his mode of operation shows that the clues were there, but they were overshadowed by the exuberance around the returns he claimed to deliver. Specifically, the Madoff team preyed on human nature in two very effective ways.
1. Scarcity. When something sounds scarce, we naturally want it more. Potential investors who contacted Madoff’s front-line team were told the firm wasn’t taking on any new clients at that time. Madoff implied there was a long waiting list and it could be quite some time until new clients were accepted. So when the call came just a week or two later with the good news that an opening was magically available, the investor was primed to take advantage of this exclusive opportunity.
2. Pressure. Like any effective scammer, Madoff pitched his investment opportunity as a limited-time offer, pushing investors to move quickly. Impressed by his performance record, investors gave in to that pressure and moved fast, with no time to conduct proper due diligence.
3 Questions That Can Flag Investment Scams
No matter who is running an investment scam—whether it’s a major operator or a small-time fraudster—there are proven ways to spot trouble upfront. By asking these three questions, you can identify the most common red flags in an investment opportunity and reduce your risk of falling victim.
1. Where is the money?
It’s critical to know exactly where your investments will be held and to ensure there are no associated conflicts of interest. It was very telling that if investors wanted Madoff to manage their money, they were required to hold the funds in his own securities company! That gave him the freedom to move their money around with no visibility to anyone outside his firm. With an honest investment manager, the situation is typically the opposite: They ask you where your assets are already held, and you agree to set up a sub-account there for your advisor to manage.
2. Who is following the money?
Any form of investment must be audited for regulatory compliance. With $50 billion under management, you might expect that Madoff used one of the Big 4 public accounting firms (like KPMG or Ernst & Young) to audit his company. Instead, his auditor was an old high school friend who operated a single-person firm out of a storefront in a strip mall and was most certainly on his payroll. Before you consider investing with anyone, make sure you know who will be auditing the funds and that you’re confident it’s a reputable company.
3. What kind of reporting will you receive?
In 2007, while at a different firm, one of my clients asked to me to look into the Madoff opportunity on his behalf. I happened to know someone else (not a client) who was investing with Madoff, so I asked if he would share a sample financial statement. What I saw shocked me: A report that looked like it was printed on the green computer paper we used on dot matrix printers back in the 1980s. The antiquated technology was a major red flag, suggesting the firm wasn’t willing to bring in an IT vendor to upgrade its systems for fear that an outsider would discover the company was creating fake statements. Before agreeing to an investment, make sure you will receive financial reports that are transparent, meaningful, and professionally prepared. Statements from the custodian where the assets are held will provide independent verification.
A Few Final Principles
In addition to keeping these three questions in mind before agreeing to any investment opportunity, guiding principles like the following may help you steer clear of scams.
- If you don’t understand an investment, don’t move forward. While you may not fully understand every detail at first glance, you should be able to after doing some homework. A good mantra to follow: Simple and low cost typically beats complex and expensive.
- Beware of anyone who gives the impression they can “walk on water.” While there are many highly successful money managers out there, no one can predict the future. If a money manager guarantees a certain rate of return, that is a good sign of a scam.
- When it comes to evaluating a potential investment opportunity, never make exceptions based on your relationship with an individual. Whether it’s your best friend making the offer or a family member telling you “it’s a no-brainer,” don’t let that keep you from doing the proper due diligence before moving ahead.
Are you looking to optimize your investment portfolio in line with your long-term goals? Contact the fee-only financial advisors at Team Hewins. We will provide reliable guidance so you can move forward with confidence and gain transparency into your portfolio’s asset allocation and diversification, investment selection, and tax efficiency.
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Team Hewins,LLC(“Team Hewins”) is an SEC-registered investment adviser; however, such registration does not imply a certain level of skill or training, and no inference to the contrary should be made. We provide this information with the understanding that we are not engaged in rendering legal, accounting, or tax services. We recommend that all investors seek out the services of competent professionals in any of the aforementioned areas. Certain information provided herein is based on third-party sources, which information, although believed to be accurate, has not been independently verified by Team Hewins. Team Hewins assumes no liability for errors and omissions in the information contained herein. Certain information contained herein constitutes forward-looking statements. Team Hewins does not guarantee the achievement of long-term goals in the portfolio review process. Nothing contained herein may be relied upon as a guarantee, promise, assurance or a representation as to the future.