The vast majority of financial advisors are honest, skilled, and ethical. However, a few bad eggs can spoil the reputation of those thousands of upstanding professionals. Bernie Madoff, the once highly regarded investment advisor turned Ponzi swindler, exemplifies the dark underbelly of the financial advisor field.
At first, Madoff appeared to be the perfect financial professional for his clients. The rich and elite had no idea their stellar returns were funded by incoming Madoff investors.
If the wealthy elite can get snookered by a financial advisor, what’s to protect the average individual from the same fate? Beware of financial advisor scams and learn how to protect yourself.
Key Takeaways
- While there are many honest financial advisors, there are also many unscrupulous ones engaging in fraudulent behavior; it's important to know the most common ones to look out for.
- Bernie Madoff has become synonymous with the Ponzi scheme, in which the payment of returns to current investors comes from money deposited by new investors; meanwhile, the advisor siphons off some of the money.
- The affinity fraud targets a group, often in combination with a Ponzi scheme, such as a religious organization or friend group, by convincing the group to go along with a scam because their friends are involved.
- Other scams include misrepresenting qualifications, such as claiming experience or certifications you don't have, or promising unrealistic returns, such as claiming an investment will generate huge numbers.
- With a "churning" scam, the advisor makes lots of unnecessary trades, which costs the customer in commissions and often results in less-than-stellar investment returns.
Ponzi Scheme
According to the Securities and Exchange Commission (SEC),“A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk.”
The Ponzi scheme is a classic scam and incorporates components of other scams as well. The investment proceeds in this classic scam are simply the new investors' monies doled out to existing clients. Without fail, the initiator of the Ponzi scheme siphons money off to fund an extravagant lifestyle.
Affinity Fraud
The affinity fraudtargets a particular group with its ploy, frequently in conjunction with a Ponzi scheme. This scam is effective because we tend to trust other members of our “tribe.” The cohort group might share the same religion, cultural background, or geographic region.
This affinity targeting makes gaining new participants in the scam easier because there is a built-in level of trust. To further con the participants, the scammer might belong to the group or pretend to be a member.
The following affinity scam-Ponzi scheme targeted Persian-Jewish community members in Los Angeles. Shervin Neman raised more than $7.5 million for investment in his so-called hedge fund. He promised that the fund invested in foreclosed real estate which would be quickly bought and then resold for a profit. In reality, Neman used the money raised to fund his extravagant lifestyle and pay off new investors.
Misrepresentation Scam
Misrepresentation of credentials is another way financial advisors scam the unsuspecting public. The field of financial planning is ripe for malfeasance because there is not one particular credential or licensing requirement to practice.
In fact, there are dozens of financial planning designations such as certified financial planner (CFP), registered investment advisor (RIA), certified public accountant (CPA), chartered financial analyst (CFA), and many more.
The public may not be aware of the designations, ethics, or requirements for certification and thus may be receiving advice from someone with no education, experience, or background in the investment advising field.
It’s quite easy for someone to hang up a shingle and start doling out advice. The scammer can then close up shop and walk away with the proceeds or swindle the unsuspecting clients with fake products.
Unrealistic Returns
Promising or even guaranteeing higher than market returns for your investment is a common trick. The popular axiom, “If it’s too good to be true, it probably isn’t” is usually accurate. It is unlikely that an advisor can offer a client returns that are unavailable to the rest of the world.
This scam preys upon the clients’ greed and dreams ofeasy money. If an advisor offers or guarantees returns higher than 12% to 15%, it is likely a scam. For example, over the last 100 years, the S&P 500 has averaged 10.53% annually. For the last 30 years, the average is 9.86%, and for the last 10 years, the average is 12.08%.
Churning
Many stockbrokers have been charged with the “churning” scam. Since traditional stockbrokers are paid when their clients buy or sell a security, they can be motivated to make unnecessary stock trades to pad their own pockets.
The churning scam involves the financial advisor making frequent buy and sell trades, which not only costs the customer in commissions but usually results in sub-optimal investment returns.
There are many other investment scams as well as additional varieties of the schemes mentioned above. Next, find out how to avoid falling prey to a shady investment advisor.
Protecting Yourself
Vet and verify the financial advisor's background. Find out if the advisor has received any disciplinary action or complaints. These websites help uncover unscrupulous advisors: www.finra.org/brokercheck, www.adviserinfo.sec.gov, www.nasaa.org, www.naic.org, and www.cfp.net.
Ask how the advisor is compensated. Is it by the commission, assets under management, fee, or a combination of payment structures? If the potential financial advisor is unclear or hedges when asked about fees, walk away. Ask for the advisor's ADV Part II document which explains the professional's services, fees, and strategies.
When vetting a potential advisor, it's important to ask for names of satisfied, long-term clients. However, while this is a good idea, in theory, this protection has a downside, as the referrals could be prescreened or friends of the advisor.
When discussing investment ideas and strategies, ask about the advantages and disadvantages of each recommendation. There are no perfect investments, and every financial product has a downside. If the advisor is unclear or you don’t understand the investment, it may not be for you. Although, you may consider gathering a second opinion.
Do not give the financial advisor a power of attorney or the ability to make trades without first consulting you. Require every financial action to be cleared with you first. Further, make certain you receive statements not only with the advisor’s letterhead, but also from the custodian, or financial institution which holds your money and investments.
How Do You Know If a Financial Advisor Is Legitimate?
There are a few ways you can check if a financial advisor is legitimate. You can check with the Financial Industry Regulatory Authority (FINRA) by visiting their BrokerCheck website or calling (800) 289-9999. You can also check the SEC's Investment Advisor Public Disclosure (IAPD) website.
Are Financial Advisors a Waste of Money?
Whether or not financial advisors are worth it will depend on the individual, their financial profile, and their financial goals. If you have a complex financial profile, many assets, and can afford an advisor, one may be worth it over the long term as the returns could outweigh the costs. Consistently check the performance of your advisor and assets to see if you are getting what you are paying for.
What Are the Red Flags of a Financial Advisor?
Some red flags of a financial advisor include not being responsive, constantly trying to sell you products that you are not interested in or that do not fit your profile, not changing strategies when they are not working, poor performance, and focusing on the short term rather than the long term.
The Bottom Line
Do not act in haste. Always take time to think about or “sleep on” a financial decision. An attempt to rush you should be a red flag. If there’s a good opportunity today, it won’t go away tomorrow. Don’t be afraid to walk away if an offer doesn’t seem right.
