TRADE ONLINE

It’s darn near impossible to open a newspaper today without at least one headline referencing financial fraud and abuse.  Frankly, the sad existence of financial criminals, whose incomprehensible greed and deceit should be labeled financial terrorism makes me sick to my stomach.  As the financial world shakes out its demons amidst a global meltdown, more
and more financial shenanigans are likely to come to light. The Bernard Madoff scheme has revealed that no investor is exempt, whether you are rich or super rich, whether you are a charity or even if you are in the “not-so-rich” column-everyone is fair game for these perpetrators.   Who is going to protect you?  It’s quite clear that federal regulators like the SEC have been asleep at the switch.  So who is an investor to trust?  How can you assure yourself that you are not a sitting duck?

The Perpetrators

There is no shortage of fresh financial scandals in the pages of the Wall Street Journal lately.  Perhaps the most visible has been the ponzi plot of Bernard Madoff and his wealthy “feeder” friends.  While the true cost of this elaborate heist may take years to uncover, the estimate of the impact hovers at over $60 billion.  Then we have Allen Stanford, the Texas Financier who may have swindled about 50,000 investors out of US $8 billion, give or take, using high, fixed rate CD’s.  The overwhelming majority of Stanford’s funds disappeared into a “black box” controlled by Stanford and his CFO, James Davis.  With a “black box model” the manager is essentially saying “trust us, we know what we are doing”. And in the latest allegation of financial fraud, as reported by the Wall Street Journal, hedge fund manager Paul Greenwood and Stephen Walsh stand accused of misappropriating over $550 million of investors’ cash and using it to fund their lavish lifestyles and rich man’s hobbies.  

Red Flags

On Wall Street, there’s no such thing as easy money or risk-less investments. If something sounds too good to be true, it probably is.  As the CFA Institute reveals, one of the red flags in the Madoff affair is that reported performance was too consistently good.  Other popular, Internet based investment scams purport to use ultra-safe “prime bank” financial
instruments from the world’s largest banks. Rewards without clear risk simply do not exist.  Here are some other clues that should have sent investors running the other direction:

The advisor who gave the investment advice and executed trades also held custody of the account (more will follow in the next paragraph on why this is important).

Madoff’s website described a sophisticated system for trading securities, but did not describe a process for managing
client assets Paying fines without admitting guilt are an unusual characteristic of the financial services industry (Madoff) Multiple complaints by regulatory agencies have been filed Account information is not transparent or difficult to obtain (ie. No online access) Statements appear doctored or printed in-house without the ability to audit account positions from an independent party

Safety Tips

As a financial advisor, please heed my suggestion-never do business with a financial professional who does not separate the brokerage custody function from the advice function. More importantly, if you do not know what the advisor is buying on your behalf, find out. This lack of transparency, or “black box model” of investing is one my biggest reservations about
investing in hedge funds. I suspect that many investors are going to start asking many more questions of their managers and might be much less tolerant of black box managers in the future.

The first tip in safeguarding your assets is to do your due diligence by visiting the websites of the regulatory agencies that govern the advisor’s business.  Investors should get in the habit of visiting both the FINRA and SEC websites to review the firm’s and the advisor’s compliance history.

Next, understand the investment strategy.  If you don’t know what you are buying, then don’t buy it.  The nature of the risks involved can vary widely and should be well understood. Buying investments for the sake of their perceived complexity may sound sexy or alluring, but may not be a wise use of your dollars.

If it sounds too good to be true, it probably is. One of the red flags in the Madoff affair is that reported performance was too consistently good.  Perfect positive returns simply do not exist.  Returns will vary year to year, some by drastic variations.  Also, be sure to match investment strategy to reported performance.   In the case of Stanford, CD rates being offered were
paying obscenely high rates.  Risk and reward are directly related.  By definition, CD’s are on the low risk to (almost) no-risk side of the spectrum.  Something just did not jive there.

Be wary of “sure things”.  Legitimate investment professionals do not promise sure bets. Financial scams often begin with the allure of inviting only a “select group of people” to participate in such “crafty investment opportunities”. Do your
homework about what, if any, regulatory oversight exists with regard to the investment products being suggested to you.  For example, mutual funds, stocks and exchange traded funds are heavily regulated, while hedge funds and certain offshore investments are significantly less regulated.

Finally, you should consider limiting your exposure to any one investment.  No more than ten percent of your assets should be invested in a single fund.  Despite recent market volatility and the increased short term correlation of global assets, diversification is one of the most fundamental and enduring investment principles.