Yesterday’s New York Times story about a huge Minneapolis Ponzi scheme involving currency trading provides some familiar lessons about investing and the finer points of protecting yourself against scams:
● Plots to separate investors from their money are a constant. Bernie Madoff, the head of the largest investment swindle in history, is cooling his heels in prison, but there are countless imitators lining up to take his place and that will never change. For every Madoff who’s fingered, prosecuted, and jailed, a large number of Bernie wannabes are running around raising capital.
● If you’re assuming that government regulation will save you, you’re dreaming. Most financial frauds are shut down long after they’ve fleeced millions from naive investors. Sometimes that’s due to incompetence by the regulators, as it was with the Madoff debacle. Yet sometimes a fraud is allowed to fester in order to gather information to aid in the prosecution. That may be legally prudent, but it leaves gullible investors at risk. The Times article about the Minneapolis fraud notes that the FBI was investigating the Ponzi scheme for months and it was all but certain that the operation was a sham. But during the FBI’s investigation, millions of dollars in new capital flowed into the fund…money that eventually “disappeared.” As a general rule, by the time the authorities enter the picture, most of the money’s gone. Some of the cash is returned, but it’s almost always a small fraction of the invested proceeds.
● There are almost always warning signs that a swindle is underway. The details of a Ponzi scheme can be convoluted, but you don’t usually need a Ph.D. in finance to smell something funky going on. Rely on your own gut instinct as a start. If something sounds too good to be true, it usually is. In the case of the Minneapolis fraud, the principal was telling would-be investors that the fund earned 1% to 2% a month consistently, without losses, in recent years—with a speculative currency trading strategy, no less. That’s the time-tested signal to run–not walk–out the door.
● It’s not obvious that the regulators are acting in a timely manner. As the Times reports, the Commodity Futures Trading Commission received damning evidence as early as 2006 that the Minneapolis fund was a sham. One investor filed a lawsuit in 2008, which was later abandoned. His lawyer forwarded related documents to the CFTC, which did nothing initially, deciding that it lacked jurisdiction to act. Maybe things are different in 2010, but why take the risk with your money?
In the end, no one will guard your assets as carefully as you will. That doesn’t mean you shouldn’t seek prudent financial advice or consider investing with competent managers. But if you’re handing over money to someone primarily because you think you’re going to make some big money quickly, that’s a sure sign that something’s amiss.
Unfortunately, many investors make this mistake, and will continue to make it. You can count on it. The swindlers certainly do. Why? The problem, dear Brutus, is partly within ourselves. As Jason Zweig explains in Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, “you will never maximize your wealth unless you optimize your brain.”
That includes reminding yourself on a regular basis that there are lots of crooks out there trying to steal your money, and that a fair amount of what’s marketed in finance is less than it seems. Sometimes a lot less.
Keep an eye out for subtle scams as well as the big ones. Some of the frauds are over-the-top schemes that are obvious swindles. But some of the deceptions are more subtle, and perhaps even legal. Avoiding huge losses is, of course, job one. Yet you can also lose a lot over long periods if you’re not careful.
How many investors overpay for beta? Many. That’s not a crime, but it should be, especially when the gouging is excessive. There are hundreds of S&P 500 index funds, for instance, but they don’t all charge rock-bottom fees.
Ultimately, there’s a fine line between legitimate and unethical investment products and strategies, and it’s not always a function of what’s legal and what’s not. But that’s a story for another day. Meantime, caveat emptor has never been more relevant. We’ve come a long way in financial economics, but some of the ancient hazards are still with us, and always will be. Act (and invest) accordingly.