Protecting Yourself From Fraud

As if the financial markets weren’t scary enough in 2008, here comes the story of a snake who decided to take advantage of people and subsequently make millions and millions of dollars doing it. Bernard Madoff, ole’ Uncle Bernie, created one of the largest Ponzi schemes ever. Basically, a Ponzi scheme is one in which current participants are paid by future participants. It is a pyramid scheme. This story especially hits home with fee-only planners such as myself.

As you probably know by now, I’ve been managing money for about 13 years. One of the hardest things about being a financial planner, especially one held to a fiduciary standard, is constantly dealing with the too good to be true scams out there. I’ve said it before and I will say it again, MOST TIMES if an investment or a product seems too good to be true, then it probably is. This past year has been a perfect example. In 2008, the S&P 500 lost 38.5%. Had you been involved in the Madoff Ponzi scheme, it is very probable you would believe your portfolio was up 8%-12%. How could this be so? It COULDN’T! Please don’t get me wrong, it is possible for individuals to have some good years picking stocks, and it is possible in 2008 there were a handful of stocks that returned 12%. What I find nearly impossible is that a properly allocated and well-diversified portfolio could return 12% in a year the market returned -38.5%. So what was leading these individuals to believe they were making money? Uncle Bernie was telling them so! There was no evidence nor proof of any of these returns. Individuals couldn’t go to Yahoo! Finance and look up the values of their holdings. Madoff held his client assets, managed them, and priced them, too. See the conflicts of interest? Investment performance can look better if the prices reported to clients are manipulated, which is allegedly how Madoff showed winning year after winning year despite the market turmoil.

While being negative is never a good thing, it is possible to limit the amount of volatility you experience through asset allocation and diversification. It is hard for individuals to brag, however, about -20% when they go to a Christmas or New Years party and hear one of their friends made 10% in a -38.5% year. Realistically, though, being down 18% less than the broad markets is a significant achievement.  Another scary aspect of this situation is the fact that some advisers fell prey to this Ponzi scheme. They would entrust their clients’ assets to someone like Bernard Madoff because they genuinely believed they were providing consistent out sized returns. These advisers may not have been stealing or cheating their clients out of money, but they were definitely not practicing due diligence to verify that these returns were legitimate.

As you listen to the podcast you’ll hear the story of a fellow NAPFA adviser out on the west coast who shares his encounter with a Ponzi scheme during the last bear market. I go on to provide you with three tips on how to avoid letting yourself get caught up in a similar scheme or fraud. I finish up by sharing with you some of the exciting changes the Money-Guy show will be making in 2009. I have received your feedback and I am accepting the challenge to kick it up a notch. I hope you had an enjoyable holiday season and I look forward to restoring order and going beyond common sense in 2009!

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