How to Protect Your Investments Against Fraud

Are you doing what you should to protect your investments against fraud?

Investments and fraud seem to go together these days like peanut butter and jelly. We may have seen yet another example of that last Friday with the scandal over at Goldman Sachs. The good old boys at Sachs have been accused of helping put together an investment and selling it to clients knowing it was a rotten stinking deal.

Why?

Because another party to the deal actually bet against the investment and sold it short. He did so knowing that when the investment went down in value (which it did) he’d make a pile of cash (which he did). Investors lost over $1.5 billion…but don’t worry. The other party I just mentioned made $1 billion on the transaction. It’s all good…right? Suffice it to say, you have to know how to protect your investments. The good news is it isn’t that tough.

Here’s a checklist of 5 items to help you do just that:

1. Never make a check payable to the person who sold you the investment.

Investments are held by third party custodians. (Read “How to Pick IRA Custodians” to learn more.) Examples of custodians are TD Waterhouse, Fidelity, Charles Schwab, etc. When you invest, that’s where your money goes. That’s who you should make your check payable to. If your adviser ever asks you to make the check payable to them, I want you to do two things:

• Leave immediately
• Call the SEC

2. Get statements.

The custodians mentioned above send out statements. They do this to let you know what the adviser is doing with your money. If the adviser is involved with any monkey business, you’ll know about it if you review those statements.

Make sure you review and confirm those statements. Once every six months, call the custodian yourself and confirm the balances. Plenty of schnooks create their own statements in an effort to cover their lying cheating tracks. If you call the custodian to confirm your balances, this won’t happen to you.

Looking for other ways to protect your assets?  Here’s a post that should interest you…..

3. Check out your advisor.

Call the SEC and NASD to make sure your financial planner has a clean record. I wouldn’t do business with anyone who had a blemish on their record – I don’t care how long ago it was.

4. Understand the track record.

If an adviser’s track record is too good to be true, it probably is. Investment returns are a function of risk. Look at risk when you evaluate managers and when you evaluate mutual fund performance too.

An adviser who does great in strong markets will probably lose more than other advisers in bad markets. That is reasonable because that’s how the market works. If an adviser’s track record is great in good years but never has a bad year, something is very wrong. That kind of record defies reality, so stay away.

5. Be wary of certain investments.

Certain investments are very attractive to rip-off artists. Hedge funds and limited partnerships (two of Bernie Madoff’s favorites) are stars among these.

Why?

Because they aren’t transparent. It’s very difficult for investors to know what’s held within those investments. It’s also very difficult to know what the investment managers are doing with the investor’s money within these types of investments.

I’m not saying that all hedge funds and limited partnerships are destined to land you in the poor house. I’m only saying that these types of investments expose you to lots more risk.

Is there a way to protect your investments against this fraud?

Well…the only thing I can think of is to buy index funds and ETFs versus mutual funds. This way, the manager is neutered. She can’t buy whatever she wants. She can only buy stocks in the index.

Does that mean you should only buy ETFs and index funds from now on?

No. This risk of this fraud happening is small and the benefit of using mutual funds (at times) far outweighs that risk, in my opinion. You have to be smart about risk management. Don’t throw the baby out with the bath water.

Waking up is risky. Crossing the street is risky. Taking a bath is risky. Do we want to be a bunch of smelly people who stay at home all day and never cross the street? No, we don’t.

As I’ve explained above, certain things are super risky and you should never do them. Other things have risks (like owning mutual funds), but those risks shouldn’t really keep you up at night. You have to be measured in your approach.

What say you?

Have you ever been taken for a ride because of one of these risks? Are there other risks I’ve overlooked? Do you think mutual funds expose investors to too much risk of fraud?