Five lessons to be learned from the Madoff scandal

Five years ago we learned about the Ponzi scheme engineered by Bernie Madoff.  How can you avoid being scammed like the people who lost billions to Madoff?  Here are five things to look for when working with an investment firm:

1. Demand Assets Be Held at Large Custodian

Be sure your assets are held by a large reputable custodian like Charles Schwab.  The custodian will be the one sending you your statements and trade confirmations.  In the Madoff scandal, all of the clients’ funds were accounted for only by Madoff’s firm, and investments were held by Madoff’s wealth management operation, which was at the heart of the scam. If client funds were held at a legitimate, large custodian like Charles Schwab, the scam would have been virtually impossible to carry out since the account statements would flow from the custodian, and the discrepancies would have been exposed immediately.

2. Fraud Diversification

Diversification is one of the primary keys to risk control.  No one should have all of his assets in a  single fund or a single stock.

3. Ask Questions and Demand Answers

When clients asked Madoff questions about his returns and management style, he refused to answer them. This is a massive red flag. Clients are entitled to answers regarding holdings, investment strategies and costs. Failure to provide this sort of information is a major warning sign.

4. If Investments or Strategy Can’t Be Readily Explained, Don’t Invest

Often investment scams are hidden in the obscure, opaque and complicated. Madoff claimed to use a “split-strike” strategy for generating steady returns for investors by investing in the largest stocks in the S&P 100 index while simultaneously buying and selling options against either these particular stocks or the S&P 100 index. If it sounds too confusing or can’t be explained simply, avoid it altogether.

5. If it Sounds Too Good to Be True watch out.

Investors often fall victim to big lies more easily than small lies. Madoff used decade-long consistency to lure investors in. Don’t believe anyone who tells you that you can earn higher returns while assuming a lower risk. If you’re realizing high returns, then you’re also accepting increased risk.

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