How to Spot a Fraud

Is your financial advisor a complete fraud?  It seems like a ridiculous question, however it is more common than you may think.  And the stakes are high.  The wrong financial advice can cost you big, potentially your entire life savings.  Smart personal financial management relies on avoiding big mistakes and one of the biggest mistakes you can make is to put your trust in someone who sees your money as way to line their own pocket.  This post identifies red-flags to look out for when interviewing or working with a financial advisor.  This list is by no means exhaustive, but it will give you a good start on some of the more common traits of self-interested fraudsters. 

Whether it’s just a great BS artist, a con-man, or a complete incompetent, the Kraken points out 5 warning signs for you to look out for.  While this is all designed to be relevant specifically to the financial advice industry, there are certainly many common threads in all pursuits and especially service businesses.  So how can you tell the advisor your talking to is a fraud?

1.       They cannot explain things in simple terms

If you ask “how does this strategy work?” and the advisor cannot answer you in a simple and concise manner, that is a problem.  If they start spouting a bunch of technical terms and advisor jargon, there is a strong possibility that they don’t have a clue.  If they say something like “it’s a dynamic hedging of risks across non-correlated markets” or “a proprietary high yield alpha strategy with a value quality overlay” it is very likely they have no idea what they are selling and are just regurgitating some phrases from a portfolio manager’s white paper.

You also need to beware of the advisor who says “the strategy is handled by experts who have a strong track record….”.  One of the worst crimes that advisors consistently commit, is selling products on the basis of past performance.  If your advisor tries to sell you something because it has a good performance record, but they cannot explain the workings, it’s a red flag.

2.       They promise high returns without the risk

I have said often on these pages, and I stress to my finance classes, that the iron-clad rule of finance is that you cannot expect higher return without taking on higher risk.  Any advisor who tries to sell you on high returns with little to no risk is either a fraud or an incompetent and you do not want either giving you investment advice.

The only way to consistently get higher returns while lowering risk is simple diversification across multiple securities and multiple asset classes.  And, diversification has its limits.  If an advisor tells you that they can achieve high returns with no risk through some fancy investment structure or loophole, you should run.

3.       They can’t explain how they get paid

As a smart consumer you need to ask your advisor “How do you get paid?”.  If they cannot respond in a clear and concise manner that you understand, you should be worried.  The most common forms of compensation for advisors is commissions on sales of securities, commissions on transactions, and a fee as a percentage of assets managed.  There can also be a blend of these three so make sure you ask about ALL the ways they get compensated.  You do not want an advisor saying that they take a percentage fee and then you find out they are also getting a kick-back from the mutual fund they just “advised” you to invest in.  An advisor who is not honest and upfront about how they get paid is highly suspect.

4.       They try to rush you

Burton Malkiel, author of A Random Walk Down Wall Street, has a great quote on this point.  “Never buy anything from someone who is out of breath.”  This is especially true for financial advice.  If your advisor tells you about a “super-hot deal” that you can get into with a world premiere investor, but “hurry up and commit because the window is closing”; I would advise to let the window close and find a new advisor.  If an advisor is trying to rush you by using a scarcity tactic like “for a limited time only” it’s usually to cover up some glaring holes in their competency.

5.       They try to explain why the “fiduciary rule is so terrible”

For a quick background, a fiduciary is someone that has a legal obligation to act in your best interest.  The fiduciary rule was issued by the Department of Labor which expands the scope of who should be considered a fiduciary.  Ultimately, it’s hard for me to see how increasing the number of people who are legally required to act in your best interest is a bad thing.  Those that make their livelihood by selling retirees hugely expensive annuities, or other high-commission products, will be less enthusiastic about it.  The honest advisors and brokers already act in a fiduciary spirit so this law change should not scare them.  A fraud will be very worried indeed.

Conclusion

Be wary out there.  As I said earlier, my focus is on the finance world, but many of these same red-flags pop up across different industries.  I will follow this up with a post about positive things to look for in a financial advisor at another time, but, for now, its getting late and I need to wrap this up.  So….

 

Until Next Time….

“A mine is just a hole in the ground with a liar standing in front of it” – Burton Malkiel

Cover photo: promotional photo from the film Dirty Rotten Scoundrels from Orion Pictures starring Michael Caine and Steve Martin.  This writer has no affiliation with the production company, or the film, or the actors…. he is simply a fan of the movie