how to avoid financial fraud

How to Beat Financial Fraud Before It Beats You

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Know the warning signs of financial fraud and how to protect your money

Charles Ponzi made $20 million through his pyramid investment scam in 1920, a sum worth hundreds of millions in today’s dollars.

That still is only a fraction of the $100 billion lost by victims of Bernie Ebbers in the WorldCom fraud or by James Paul Lewis Jr in the 2003 Financial Advisory Consultants scam. Add another $3 billion stolen by Michael de Guzman and $200 million by the notorious Wolf of Wall Street, Jordan Belfort, and the losses are staggering.

These five famous cases of investment fraud amounted to losses of more than $103.5 billion for victims…

Want to know how much jail time the scammers got?

Just 62 years combined…less than 13 years each on average for destroying the financial lives of millions of Americans.

The fact that financial fraud is rarely prosecuted and sentences amount to the proverbial slap on the wrist means scams will always be a risk of investing.

Financial fraud is out there but it shouldn’t scare you from putting your money to work and reaching your investment goals. Understanding the different types of financial fraud as well as the warning signs will help keep your money safe.

How Bad is Financial Fraud?

A survey by the Federal Trade Commission (FTC) found that 30.2 million Americans, 13.5% of the population, were victims of financial fraud within the previous 12 months. The problem with surveys is that they likely underestimate the problem by a significant number because people don’t realize they have been a victim.

types of financial fraud
Types of Financial Fraud and Losses

The total annual losses from securities fraud and other scams is also difficult to measure. A Fraud Enforcement Task Force run by the Justice Department found more than $8 billion of losses to investment fraud in 2010 and total financial fraud has been estimated at more than $50 billion a year.

Law enforcement and regulatory agencies don’t have the manpower to investigate and close financial fraud cases. The FBI had 1,500 pending cases of commodities and securities fraud open in 2009. That’s 1,500 cases of potential fraud and billions of dollars in losses unreported.

The 2008 discovery of the Bernie Madoff fraud amounted to over $50 billion alone!

5 Investment Scam Warning Signs

Financial fraud ranges from simple lies to complex schemes set up by teams of fraudsters but most have a few things in common. Scammers trick investors with promises of instant wealth and hype around an ‘opportunity’. It’s in these investment fraud warning signs that you can avoid being their next victim.

Promises of high returns and no risk. Investing is about taking risk for a future return. The problem is that many people try to separate the risk and ‘future’ from investing. They want returns with little or no risk and they want them now.

Scammers play into this with promises of easy money and quick payoffs. They ‘guarantee’ returns or place very high odds on a large payout. Remember, the only guaranteed return is on the U.S. Treasury bond and some life insurance products. All other investing involves risk.

warning signs investment scams returnsThe best way to avoid getting trapped by these promises of high returns is to understand what kind of return can be rationally expected within the different asset classes.

Asset class returns in any given year may be higher or lower but nobody really knows how much so ahead of time. Any investment adviser that tells you they can get you significantly higher returns than the ones listed is either naïve or suspect of financial fraud.

Unregistered persons. People selling investment or insurance products must be registered with state and federal regulators. Always check whether the person offering to sell you the investment is registered and licensed, even if they come recommended by someone you know.

Besides checking to see if they are registered, you will also be able to see if they have been reprimanded for shady practices in the past.

**These next three bullet points are the most important part of this entire article! Understanding how to check regulator databases for financial fraud and red flags is the easiest and best way to avoid being a victim.

Using these online databases to check your investment adviser is easy. You can enter names, company names or registration numbers. You can even enter a location to see all the advisers registered in an area.

check for financial fraud

Searching for an adviser’s record will show you a lot of information including:

  • Number of years’ experience in the industry
  • Number of firms for which they’ve worked and a timeline
  • State licenses and exams passed
  • Required disclosures of customer complaints, arbitrations, regulatory actions of misconduct, terminations, bankruptcies and criminal proceedings

If you don’t find your investment adviser, ask them if they are registered. Make sure to double-check any name they give you that differs from the one you know them by and ALWAYS report any suspected fraud to regulators.

Red flags in investment adviser’s background. Just because an investment adviser is registered and licensed doesn’t mean they have your best interests in mind. Nearly one-in-fourteen investment advisers have been disciplined for misconduct relating to client assets.

That might not sound too bad until it’s your money.

A survey by the University of Chicago found that adviser misconduct was even worse at some large investment firms. More than 2,000 advisers at Oppenheimer & Company, nearly one-in-five of the staff, had been disciplined for misconduct.

adviser misconduct and financial fraud

Not only should you check with the SEC, FINRA and your state regulator to make sure the investment adviser is registered but make sure you take a critical look at any disciplinary actions against them.

When checking on misconduct and potential investment fraud, watch for

  • Investment firms or their employees that have been expelled from the securities industry
  • Personal bankruptcy
  • Termination by an employer
  • Adviser subject to an internal review by employer
  • A high number of client complaints
  • Failed industry qualifications exams
  • Federal tax liens
  • Advisers that change employers often

High pressure sells tactics are often used by investment scammers because they don’t know how long they’ll get away with the scam. They may be under pressure by other investors to return funds and need your money to cover their losses or may already be under review by authorities.

Investing is a life-long affair and you should never be pressured for fear of ‘missing out’ on a big gain. Even missing out on a year of strong stock market gains is not going to materially affect your nest egg when viewed over decades.

Always talk with your partner or a friend when considering an investment outside your normal portfolio allocation to stocks and bonds. Scammers will try to humiliate you for having to ‘ask for permission’ to invest your money but it is only a trick to pressure you into a quick decision.

Free meals seminars and vacation packages are a favorite of financial fraud and marginal investments.

We’ve all seen the commercials. An amazing vacation package of something like seven nights in Orlando, free tickets to Disney World plus an additional free cruise is offered by some announcer that sounds more excited than anyone ever should be.

If you ever go to one of these, you find that hidden taxes and fees increase costs by hundreds of dollars. You also find that you have to sit through a sales presentation for an investment or vacation timeshare.

Many of these are not outright scams while others may fit the definition. Either way, it should be a warning sign that the salesperson needs to bring you in on prizes or merits other than the investment itself.

A real investment adviser will never try to ‘bribe’ you with freebies to sell you an investment.

Avoid these warning signs in financial fraud, make real money over decades of investing and pay for your Disney vacation with the returns!

How Fraudsters Try to Look Legit

There is a lot of money in financial fraud…billions of dollars, and fraudsters know that spending a little money to make their scam seem legit will pay off in the long-run.

This money is spent on professional-looking websites, documents and marketing material.

Fraudsters may give you the name of a regulatory authority and a contact number to verify their credentials. The agency may be legit but the contact number will go to a call center operated by the scam.

  • Always do your own search for contact numbers to reach regulatory authorities. If the phone number given by the investment adviser differs from the one you found online, report it immediately! You may be saving yourself and a lot of victims.

Another common trick for investment scams is to use the regulatory agency’s seal or logo on company documents. The scammer will either explicitly say or imply that the regulatory body, usually the SEC or FINRA, has endorsed the investment.

  • U.S. and state regulators do not endorse or allow their logos to be shown on private company documents. This may make the investment seem legitimate but it is illegal to do so.

It’s difficult sometimes to look past a flashy website or professionally-made marketing materials.

  • Be wary of investment brochures using many different colors or text fonts
  • Be wary of websites or marketing material that uses lots of graphic design to draw your eye to call or buy buttons
  • Marketing materials that use multiple pictures of happy couples may be trying to show you what you want to see rather than the reality of the investment

I’ve worked for nearly a decade helping investment firms develop reports and advisory services. I can tell you that the legit investment companies don’t put much money into design and aesthetic appeal of their materials. They sell their advice on the quality of their analysis and past performance, not on a glossy brochure that catches the eye.

Different Types of Investment Fraud

There are several common types of investment fraud but most share some common warning signs. Read through the different types of scams and you’ll start to pick up on similarities. Understanding these similarities will help you avoid being a victim of financial fraud.

How to Avoid Ponzi Schemes

A Ponzi scam is a where new investor money is used to pay the returns to previous investors and to fund the fraudster’s lavish lifestyle. The scam promises high returns and little risk, often showing proof from other investors of the returns received.

how to avoid financial fraudPonzi schemes require a continuous flow of new money to pay returns. This means scams rarely last more than five or ten years because fraudsters find it difficult to reach new investors during tough economic times. The scams also eventually collapse under their own weight as the number of previous investors and the amount of new money needed becomes too much for the scammer.

  • How consistent have returns been on the investment? Ponzi schemes generally pay out very consistent returns over years. It makes the investment look more reliable and safe but is one of the key warning signs. Legit investment returns will rise and fall from year to year.
  • Do an internet search and try to find previous investors to get their story and how long they have been investing.
  • Be wary of investments not registered with the SEC or state regulators

How to Avoid Affinity Fraud

Affinity fraud is one of the most heinous types of financial fraud because it targets groups and preys on their trust. Religious and elderly communities are often targeted because of the close bond people have in the group.

Typically, a scammer will approach a few individuals in the group and get them involved in the investment. After being provided out-sized returns, they are asked for an introduction to other members of the group. The scam spreads quickly because of the trust involved in the introduction.

Besides the loss of life-savings, affinity fraud destroys the community and groups it deceives.

  • Always check an investment representatives background, even if they come highly-recommended by someone you trust.
  • Be wary of high returns gained over a short-period, less than a year or two, by those making the introduction to the investment representative. They may have been the bait to attract the rest of the members in your group.

How to Avoid the Pump-and-Dump Stock Scam

Pump-and-dump stock scams involve two stages.

  • A stock’s price is first manipulated through false statements, press releases and through artificial buying by scammers. The sudden interest shoots the shares higher.
  • Fraudsters attract other investors to buy into the shares, promising future returns based on past performance and fake news. In reality, the new investors are just driving the price higher so the previous investors can cash out with a huge profit.

Before the internet age, these pump-and-dump scams used to be conducted through ‘boiler rooms’. These were rooms of scammers and phones that would call investors non-stop to pitch their ‘investment advice’. The ease of the internet has taken these scams to message boards and forums though some old-school phone scams still pop up occasionally.

  • Trading on insider information is illegal! Fraudsters will claim to have private information about a stock. If someone claims to have secret information that will send a stock higher, why are they sharing it with you? This is the biggest warning sign of the pump-and-dump investment scam.
  • Check the Average Daily Volume of a stock over the previous month and last year, all available on Yahoo Finance. Exceptionally high trading volume may be a sign of manipulation.
  • Pump-and-Dump scams usually involve very small companies with market cap of less than $150 million. This makes it easier for scammers to manipulate the share price with a quick increase in buying.

How to Avoid Binary Options Fraud

Binary options have become popular over the last decade and fraud has increased significantly. Binary options are a type of options contract in which the payout depends on whether the stock price is above or below a certain amount on the expiration day.

binary options financial fraudBinary options are an all-or-nothing investment and does not give you the right to buy the stock as is the case with other options investing. I won’t say binary options are a bad investment but they are much more like gambling than other investments.

Binary options fraud is usually conducted through an online trading platform selling the products. The websites may legitimately offer the investments but then manipulate software to generate investor losses or they might just be completely fictitious to steal your financial information.

  • Check the background of the investment firm or website with regulatory databases. Platforms appearing out of nowhere and not registered are a warning sign of fraud.
  • Be wary of binary options platforms that overstate high returns on the investment. The all-or-nothing nature of the payoff means that these investments have a relatively low average return when accounting for total losses on some investments.

Asking Questions to Avoid Investment Fraud

The best way to avoid investment fraud is to ask questions, both to yourself and of the investment representative.

Don’t be shy about asking questions of the salesperson. Any legit investment adviser will treat you with respect and acknowledge the validity of your questions. They will answer them directly and will help you understand. Financial fraudsters will make fun of you for your lack of trust or will try to humiliate you for not being able to understand what they have been saying.

Questions to ask yourself before making an investment:

  • How much higher are the implied returns of this investment compared to its asset class (stocks, bonds, real estate, commodities, peer lending, private equity) and compared to index returns of similar investments?
    • Within the asset classes, investments can be grouped by sectors and other factors with these groups usually used within an investment index that tracks the returns.
  • Is the representative implying that you will make a higher return without a higher risk? High returns are possible but they always come with higher risk.
  • Is the representative trying to get you to cut them a check RIGHT NOW? How do they react when you ask for a few days to think about it and talk to your partner?

Questions to ask the investment representative:

  • What are the annualized returns on the investment compared to the most relevant index? Ask for annualized comparisons dating back longer than five and even ten years.
    • The eight-year bull market in stocks is making mutual fund and investment returns look stellar when presented on a three- and five-year return. How do those returns look over ten- and 20-years?
    • Be critical when presented with relevant indexes. Does the investment really compare to the one being sold in types of investments and asset class? Do a search for exchange traded funds (ETFs) that invest in the same types of investments to compare returns.
  • Ask the representative for the name and number under which they are registered with regulatory agencies.
  • What are the total investing fees to purchase, maintain and sell this investment? How much does the investment have to increase in value before I break even?
  • What are the specific risks to the investment? What is the maximum I could lose?
    • Any professional that cannot tell you specific risks or that tries to downplay risks is trying to hide something.
  • Where can I get more information about the investment?
    • Be skeptical if the representative will not provide sources of information not controlled by their company.

Financial fraud shouldn’t keep you from investing your money and reaching your financial goals. There are scammers out there but the majority of investment professionals are there to help you make money. Avoiding being the victim of investment fraud is a matter of asking questions and knowing the warning signs of a scam. When in doubt, take your time and err on the side of being conservative with your investments.

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