The Bernie Madoff scandal remains one of the largest financial frauds in history, with important lessons for investors of all levels. Here are key takeaways to protect yourself from similar investment scams.
Key Lessons from the Madoff Scandal
- Third-Party Custody is Essential: Ensuring the investors' money is deposited in a third-party firm, and being wary for the fact that the returns generated by the investment advisory firm are stable even in down market, are the two biggest aspects to look for.
- Verify Fund Custody: It is the job of the investor/consumer to check whether the financial advisor uses a trusted third-party firm to hold the funds received from individual investors, so that the financial advisor cannot misuse the funds for his own lifestyle. By using these two-factor authentication, the customers are aware when their funds are removed from the account.
- Be Suspicious of Guaranteed Returns: Investment returns that are guaranteed by the financial advisor upfront are another red flag. Because if the financial advisor can give stable returns consistently on the investor's money even in the bear market, which is quite impossible to achieve. The returns might be 5 percent or 10 percent, it is considered as a red flag because if the money is invested elsewhere other than the UST (government bonds), the returns generated must have some degree of variance.
- Check Advisor Credentials: The consumers/investors can check the investment adviser public disclosure website, which is operated by the SEC and the financial industry regulatory authority's resource that lists the registered brokers, if a person name is listed in either of the list means that the person is licensed or registered with a firm, this fact means they have met minimum level of credentials and have certain experience in the industry they are dealing with.
- Research Complaints: The investors can check the regulatory website to see whether any complaints are raised against the advisor, if there are one or two complaints against the advisor or the firm entrusted to carry out the investments then, it is better to run.
- Watch for Unrealistic Performance: Hyper-trading activity is not considered a red flag if the investors/consumers' funds that are managed by the advisor lose money in the bear market, it is considered a red flag if the portfolio managed by the advisor performs below the stock market index, or the bond benchmark regardless of the economic situation.
- Communication Red Flags: Unsatisfactory or prolonged duration taken to respond to customer queries is another red flag, and if the advisory firm asks to talk through the company's email other than the regular advisory channels then it should raise suspicious.
- Beware of Pyramid Schemes: Beware of top-earning recruiters, one of the tactics the scammers use in recruiting new investors is with the help of others who have benefited from the scheme (pyramid scheme), the recruiters without realizing that they are in a pyramid scheme give testimonials of their high returns to other investors and urge them to invest in the fund managed by a said financial advisor.
- Understand Your Investments: If you do not understand how the money is being invested in order to gain returns, do not invest in such funds, especially in the Madoff case, the investors had no idea how Madoff was generating double-digit returns year after year. When Madoff was confronted against the same, he had no answer, he made sure that his investment strategies are so unique that it is kept as a secret. Furthermore, avoid placing all your money in a single basket especially if the funds are managed by a single advisor. It is better if you diversify your portfolio in order to minimize the risk associated with investing. It is better of investing in stock index funds which generates low returns but better suits the investors that have zero knowledge regarding investing.
- Ask Questions: The information asymmetry, which was clear in the case of Madoff scam was the main reason that led Madoff to prolong the duration of the scam since the investors were borne from asking questions about the investment strategies, hence, we can say that if the investor is discouraged from asking questions, then that might be a red flag.
Even though the SEC made considerable regulatory changes after the Madoff scam, still some crooks go under the radar, hence, it is necessary to educate the investors about the steps that they can take before investing their money in a fund, the SEC is carrying out a huge campaign to educate the investors about the regulatory norms and the red flags to look for while investing.