How To Avoid The Next Madoff

PERSONAL FINANCE

Being Curious About Your Adviser And Diligent About Your Money Can Help Keep Investments Out Of Harm's Way

Your Financial Adviser

July 05, 2009|By EILEEN AMBROSE

It would be nice if Bernie Madoff's 150-year prison sentence would scare straight any financial adviser who ever thought of duping a client.

But that's not likely.

While most advisers are honest, there will always be some who will betray clients' trust for a quick buck - or billion.

Last year's stock market crash devastated portfolios, causing many investors to realize they could use the help of a professional. Unfortunately, it coincides with the Madoff scandal and other high-profile cases of suspected fraud. Investor distrust of advisers is likely higher than ever.

So, if you want to hire a financial adviser, how can you avoid a Bernie Madoff-type situation? There is no foolproof way to prevent fraud, particularly if you have someone determined to cheat. But by taking some simple steps, you can lessen your chance of being a victim, or at least reduce the damage from a fraud.

Trust, but verify

Madoff's crime is a case of affinity fraud, where many of the victims ran in his social circle and trusted him because of that.

You can still ask friends, family, co-workers or other professionals you work with for suggestions on financial advisers. But don't stop there. Once you get recommendations, dig into the advisers' backgrounds.

Start by checking their background, including disciplinary records and customer complaints, with regulators. Granted, the Securities and Exchange Commission dropped the ball when it came to Madoff, not heeding warnings about him for years. Still, records are worth checking.

Brokers are licensed by the Financial Industry Regulatory Authority, or FINRA. Investment advisers managing less than $25 million in assets are licensed by state regulators, while the SEC regulates those with more assets.

Records can overlap, so start with your state regulator. Marylanders can check on brokers and advisers by contacting the state Securities Division at 410-576-7048. The agency can provide more information than what's available through FINRA because of a broader state public information law, says Securities Commissioner Melanie Senter Lubin.

FINRA posts brokers' records online under BrokerCheck at finra.org. Even if there is no disciplinary blemish, be wary of a broker who switches firms every year, regulators say.

Understand, too, that investment advisers and brokers have different levels of responsibility to clients.

Investment advisers have a fiduciary responsibility to put their client's best interest first. Brokers must make sure investments are "suitable" for the clients, which doesn't necessarily mean the investment will have the lowest commission.

This could change, though. The Obama administration's proposed regulatory reform calls for brokers to have a fiduciary duty to clients.

Watch for red flags

Madoff claimed returns of 10 percent to 12 percent year after year. No one can produce such consistently high results.

"Here you had to ask, 'If Warren Buffet couldn't do this, how could Bernie Madoff do it?' " says Leonard Rosenthal, a finance professor at Bentley University.

Be wary when advisers claim investment returns that are much higher than what similar investments are earning. "They can't do that without taking a lot of risk," Rosenthal says. Madoff didn't take just anyone as a client, and his investors often felt lucky to be allowed to join his exclusive club. Exclusivity is often part of frauds because it "just pulls people in all the time," says Lubin. "You can get something that you can't get elsewhere."

Look for outside custodians

Madoff served as the custodian of his clients' assets, and thus was able to fabricate statements that showed investors were making money.

Choose an adviser that has an outside custodian, say Charles Schwab or TD Ameritrade, that will hold your assets and generate independent statements. Plus, you can always call the outside custodian to double-check your balances.

Similarly, look for an adviser with a reputable, recognizable auditor, says Fred Joseph, president of the North American Securities Administrators Association. Madoff's auditor was a tiny, unknown firm, unusual given the billions of dollars he managed, Joseph says.

Diversify

Many of Madoff's clients invested their entire savings with him, and their lives were upended when they lost all their money. "Simple advice, but very effective: diversify. Don't put all your assets with one manager," says Brian Bruce, a finance professor at Southern Methodist University.

Interview prospects

Meet with at least three professionals before hiring one. Ask advisers about their education, training, work experience and how they are compensated. Find out if the adviser has experience working with clients in your situation, say, a 25-year-old just starting out or a 60-year-old needing retirement and estate planning, says Gerri Walsh, vice president of investor education at FINRA.

Many advisers have an alphabet of professional designations after their names. Some are meaningful, others aren't. None guarantees that an adviser is honest.

FINRA posts descriptions of the designations on its Web site. The group also offers online "Scam" and "Risk" meters, to determine if an investment might be a scam or if you're at risk of becoming a victim.

Keep your eyes open

Once you hire a professional, don't ignore your investments. Read your statements. Make sure there aren't any transactions you didn't authorize, Walsh says. If so, contact regulators immediately.

How to protect yourself

1. Trust, but verify

Ask friends, family, co-workers or other professionals you work with for suggestions on financial advisers. But once you get recommendations, dig into the advisers' backgrounds.

2. Watch for red flags

Be wary when advisers claim investment returns that are much higher than what similar investments are earning.

3. Diversify

Don't put all your assets with one manager.

4. Interview prospects

Meet with at least three professionals before hiring one.

5. Keep your eyes open

Once you hire a professional, don't ignore your investments.

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