3 Ways to Avoid Financial Fraud

by Dr. Mark Skousen

Three weeks ago, in Investment U Issue #898, I promised you a 30% return on my “Keynesian investment strategy” of buying a deeply discounted fund, the John Hancock Preferred Income Fund (HPI).

Guess what? It’s already achieved the goal of 30% return (including a nice dividend). Today, I’ll show you how to keep your hard-earned profits from being stolen by some unscrupulous broker or money manager through financial fraud.

Sadly, quite a few wealthy individuals lost their entire fortune and are now penniless because they invested their money with Wall Street veteran Bernie Madoff. He is alleged to have lost $50 billion. By taking some simple preventative steps, you can avoid being wiped out by financial fraud and financial scam artists.

Vital Financial Fraud Lessons From the Madoff-Ponzi Scheme

There are some vital lessons to learn from this incredible Madoff-Ponzi financial fraud scheme.

First, you can’t count on the federal government, especially the Securities & Exchange Commission (SEC), to protect your hard-earned money. The feds are like the police: They are better at finding criminals than preventing crime.

In fact, there is a fundamental reason why the SEC misses most fraud cases: The SEC is often in bed with the investment houses. George Stigler, professor of economics at University of Chicago and long-time colleague of Milton Friedman, demonstrated this many years ago. Over time, regulatory agencies are corrupted by the companies they regulate.

Not surprisingly, many ex-SEC employees are hired by broker/dealers to keep the SEC at bay. That’s apparently what happened at Madoff Investment Securities. A team of SEC lawyers investigated Madoff’s broker/dealership a few years ago and found nothing amiss.

Second, the Madoff case is so large and hurtful to so many investors, from Steven Spielberg to small Jewish foundations, that the Democratically-controlled Congress will have another big reason to impose another heavy dose of regulation on Wall Street. Sarbanes-Oxley will look like a band-aid compared to what’s coming down Pennsylvania Avenue.

Who’s To Blame For Financial Fraud?

Of course, looking back, investors have only themselves to blame if they got caught losing their shirt in bad investments and/or financial fraud. Sure, Bernie Madoff had impeccable credentials on Wall Street. If you can’t trust the former chairman (founder) of Nasdaq, who can you trust?

But there were plenty of red flags:

• Refusal of promoters to reveal exactly how Madoff made money: Clients were always told that his option strategy on index funds was “too complex” to explain. Smart investors will avoid managed accounts they don’t understand.
• Accounts made money too consistently. Madoff’s managed accounts showed steady returns of 10-12% year in and year out, through bull and bear markets. Madoff promoters claimed that Madoff’s funds “never” lost money - no such guarantee is possible with managed accounts.
• Madoff’s managed accounts had no separate custodian and no independent outside auditor (other than a small 3-man accounting firm).

3 Simple Rules For Avoiding Financial Fraud

How can you avoid financial fraud? There are three simple rules:

• Manage your own funds as much as possible with large, reputable discount brokers where the federal insurance guarantees accounts.
• If you are still tempted to turn your money over to another’s management, I urge you to make sure you diversify into several managed accounts. It’ll ensure that no one account is so large that it leaves you penniless if financial fraud happens. Managed accounts should also include publicly-traded, no-load mutual funds and exchange traded funds/notes, whose value can be tracked daily.
• And most importantly, you should make sure all managed accounts have separate custodians and independent, outside accountants to audit your accounts.

Comments

[Ziravan:]

"He is alleged to have lost $50 billion."

Words have meaning. His INVESTORS might have "lost" and aggregate of 50BN. But Madoff STOLE that much; he didn't "lose" it.

Jan 04 01:49 PM

[bigmoney:]

self management is not easy for time constrained working folks. Maybe people need a manager of fund managers to prevent over-concentration in any one fund manager. And since the manager of managers might collude with the fund managers, it would be good to hire manager of fund managers auditor.

Jan 04 09:53 PM

[Gedankonomist:]

So would you suggest avoiding Berkshire Hathaway?

"But there were plenty of red flags:

* Refusal of promoters to reveal exactly how Madoff made money: Clients were always told that his option strategy on index funds was “too complex” to explain. Smart investors will avoid managed accounts they don’t understand.
* Accounts made money too consistently. Madoff’s managed accounts showed steady returns of 10-12% year in and year out, through bull and bear markets. Madoff promoters claimed that Madoff’s funds “never” lost money - no such guarantee is possible with managed accounts.
* Madoff’s managed accounts had no separate custodian and no independent outside auditor (other than a small 3-man accounting firm)."

Jan 06 12:07 AM