How to Smell a Rat

Introduction

In the world of finance, few crimes are as devastating as Ponzi schemes and investment fraud. These schemes can wipe out people's life savings, bankrupt charities, and destroy communities. Ken Fisher's book "How to Smell a Rat" is a crucial guide for anyone looking to protect their hard-earned money from financial predators.

Fisher, a renowned investment analyst, provides readers with the tools to spot potential fraudsters and avoid falling victim to their schemes. This book is especially relevant in the wake of high-profile cases like Bernie Madoff's $65 billion fraud, which affected everyone from Hollywood celebrities to charitable foundations.

"How to Smell a Rat" breaks down the common tactics used by financial con artists and offers practical advice on how to safeguard your investments. By learning to recognize the warning signs of fraud, readers can make more informed decisions about their financial future and avoid the heartbreak of losing everything to a scam.

Key Idea #1: Separate Your Adviser from Your Assets

One of the most important lessons in "How to Smell a Rat" is the need to keep your financial adviser separate from your assets. This separation is crucial for protecting your investments from potential fraud or mismanagement.

The Role of a Custodian

Fisher emphasizes the importance of using a custodian - a financial institution that holds and safeguards your securities. A custodian acts as a buffer between your money and your financial adviser, providing an extra layer of security and oversight. Here's why custodians are so important:

1. They don't have access to your accounts or investment profits
2. They don't earn commissions on your stock purchases
3. They prevent unauthorized withdrawals from your accounts
4. They verify all investments and transactions
5. They provide 24/7 online access to your accounts
6. They issue their own account statements, which you can cross-check with your adviser's statements

The Danger of Combined Roles

When your financial adviser also has custody of your assets, it creates a dangerous situation. This setup allows an unscrupulous adviser to:

1. Directly access your funds
2. Make unauthorized withdrawals
3. Provide false or misleading account statements
4. Cover up fraudulent activities

Fisher points out that many high-profile fraud cases, including Bernie Madoff's scheme, involved advisers who had direct custody of their clients' assets. By separating these roles, you create a system of checks and balances that makes it much harder for fraud to occur.

Key Idea #2: Be Wary of Consistently High Returns

While everyone dreams of finding an investment that consistently outperforms the market, Fisher warns that such promises are often too good to be true. He provides several red flags to watch out for when evaluating an adviser's performance claims:

Unrealistic Promises

Be extremely cautious of advisers who promise incredibly high returns, such as 40% or 50% annually. These kinds of returns are simply not sustainable over the long term. While it's possible for an adviser to have one or two exceptional years, there's no secret formula for beating the market by such extreme margins year after year.

Suspiciously Consistent Returns

Equally suspicious are advisers who claim to have consistent above-average returns. Fisher explains that most markets are volatile, with significant ups and downs. In fact, according to Global Financial Data, two-thirds of all S&P 500 annual returns since 1926 were either below zero or above 20%, with only one-third falling in the "average" range of 0-20%.

The Reality of Market Performance

Fisher reminds readers that even legendary investors like Warren Buffett have bad years. When comparing the performance of top money managers, he found that they got it wrong about 30% of the time. This is normal and expected in the world of investing.

The Madoff Example

Bernie Madoff's fraud is a perfect example of why consistent, high returns should be viewed with skepticism. Madoff claimed to generate steady returns of 10-12% annually, regardless of market conditions. This impossibly smooth performance was a key indicator that something was amiss, but many investors overlooked it due to greed or a lack of understanding.

Key Idea #3: Demand Clear Explanations of Investment Strategies

Fisher stresses the importance of understanding your adviser's investment strategy. If you can't grasp how your money is being invested, you're putting yourself at risk. Here's what to look out for:

Avoid Jargon and Complexity

Be wary of advisers who use complex jargon or refuse to explain their strategies in simple terms. A legitimate investment strategy should be explainable in plain English. If your adviser can't or won't do this, it's a red flag. It could mean:

1. They don't understand the strategy themselves
2. They're trying to impress you with fancy-sounding terms
3. They're hiding something

Strategies vs. Tactics

Fisher makes an important distinction between investment strategies and tactics. A strategy is the overall plan for how your money will be invested, while tactics are the specific tools used to implement that strategy. Be cautious of advisers who present a set of tactics as if it were a complete strategy. For example, saying "we'll earn great returns by investing in derivatives" is not a strategy - it's just mentioning a tactic without explaining the underlying plan.

The Importance of Transparency

A trustworthy adviser should be able to clearly explain:

1. What they're investing in
2. Why they're choosing those investments
3. How they expect to generate returns
4. What risks are involved

If your adviser can't or won't provide this information, it's time to find a new one.

Key Idea #4: Don't Be Fooled by Exclusivity or Flashy Displays

Fisher warns readers not to be swayed by advisers who claim to offer exclusive services or who surround themselves with expensive trappings. These can often be tactics used to distract from a lack of substance or even fraudulent activities.

The Illusion of Exclusivity

Many fraudsters, including Bernie Madoff, use the lure of exclusivity to attract clients. They may claim that their services are only available to a select group of investors or require an introduction from an existing client. While this can make potential clients feel special, it's often just a marketing tactic. Fisher points out that true exclusivity in investing rarely provides any real benefits to clients.

Legitimate Reasons for Selectivity

There are some valid reasons why an adviser might be selective about their clients. For example:

1. Their strategy may require a minimum investment amount to be effective
2. They may specialize in serving a particular type of client (e.g., high net worth individuals or small businesses)

However, these reasons should be clearly explained and should benefit the client, not just the adviser.

Beware of Ostentatious Displays

Fisher cautions against being impressed by advisers who surround themselves with expensive offices, luxury cars, or other signs of wealth. He reminds readers that in the world of financial advising, any expenditures ultimately come out of the clients' pockets. Extravagant displays could indicate that:

1. The adviser is not managing client fees efficiently
2. They're more focused on their own lifestyle than on their clients' interests
3. They're trying to distract clients from examining their actual performance

Focus on Substance, Not Style

Instead of being swayed by exclusivity or flashy displays, Fisher encourages readers to focus on the adviser's actual investment strategy, track record, and ability to explain their approach clearly. These are the factors that truly matter when it comes to protecting and growing your wealth.

Key Idea #5: Don't Trust Advisers Based on Charity Work or Reputation Alone

Fisher warns readers not to be swayed by an adviser's charitable donations or seemingly good reputation. While these can be positive attributes, they don't guarantee honesty or competence in financial management.

The Illusion of Free Services

Be extremely cautious of advisers who offer to manage your money for free. Fisher explains that financial advisers always get paid somehow. If they're not charging you directly, they may be:

1. Earning commissions on product recommendations (which can create conflicts of interest)
2. Planning to make money through hidden fees or charges
3. In the worst cases, intending to embezzle your funds

The Bernie Madoff Example

Fisher uses Bernie Madoff as a cautionary tale. Madoff didn't charge typical adviser fees, only transaction costs. This seemed attractive to clients but created perverse incentives and masked his fraudulent activities.

Reputation and Charitable Giving

While a good reputation and charitable donations can be positive signs, they're not guarantees of trustworthiness. Fisher points out that even notorious fraudsters have used charitable giving to burnish their image:

1. Bernie Madoff donated over $1 million to the Lymphoma Research Foundation in 2007
2. Allen Stanford hired lobbyists to support anti-fraud legislation

These actions helped create an aura of respectability that made it easier for them to continue their fraudulent activities.

Look Beyond Surface Impressions

Instead of relying on reputation or charitable giving, Fisher advises readers to:

1. Thoroughly investigate an adviser's background and qualifications
2. Understand their investment strategy and approach
3. Check for any regulatory issues or complaints
4. Verify their claims about performance and returns

Key Idea #6: Don't Rely Solely on Friend Recommendations or Shared Affiliations

Fisher cautions against choosing a financial adviser based solely on recommendations from friends or shared social connections. While these can be starting points, they're not sufficient for making such an important decision.

The Limits of Friend Recommendations

Relying on a friend's recommendation for a financial adviser can be risky because:

1. Your friend may not have done proper due diligence
2. They might not understand what makes a good adviser
3. They could have chosen their adviser based on another friend's recommendation

The Madoff Referral System

Fisher explains how Bernie Madoff exploited the trust people place in friend recommendations. Madoff used a system of "unofficial" agents who referred new clients to him, sometimes even receiving compensation for these referrals. This created a network of trust that helped mask his fraudulent activities.

The Danger of Shared Affiliations

People tend to trust others who belong to the same social groups, such as religious communities, clubs, or alumni associations. However, Fisher warns that shared affiliations don't guarantee financial expertise or trustworthiness. He points out that many fraudsters exploit these connections to gain trust and access to potential victims.

The Importance of Independent Verification

Instead of relying on recommendations or shared affiliations, Fisher advises:

1. Conducting your own research on potential advisers
2. Checking their credentials and regulatory history
3. Understanding their investment philosophy and approach
4. Verifying their claims about performance and returns

While recommendations from friends or shared affiliations can be starting points, they should never be the sole basis for choosing a financial adviser.

Key Idea #7: Understand the Limits of SEC Protection

Fisher explains the role of the U.S. Securities and Exchange Commission (SEC) in protecting investors, while also highlighting its limitations. Understanding these can help investors take more responsibility for their own financial safety.

The Role of the SEC

The SEC plays an important role in regulating the financial industry and protecting investors:

1. It requires registration for advisers managing over $110 million in assets
2. It mandates disclosure of important information through Form ADV
3. It conducts surprise inspections of registered firms
4. It enforces securities laws and regulations

Limitations of SEC Oversight

Despite its efforts, the SEC can't catch all fraudsters before they cause harm:

1. The SEC lacks resources to constantly monitor all registered firms
2. Thorough inspections are time-consuming and can't cover every detail
3. Fraudsters can provide misleading information in their filings

The Allen Stanford Example

Fisher uses the case of Allen Stanford to illustrate how fraudsters can slip through regulatory cracks. Stanford registered his firm but didn't list himself as someone who directs investments, allowing him to avoid disclosing suspicious information about his past.

The Importance of Personal Diligence

While the SEC provides an important layer of protection, Fisher emphasizes that investors must take responsibility for vetting their financial advisers. This includes:

1. Checking an adviser's registration and disciplinary history
2. Understanding their investment strategy and approach
3. Verifying their claims about performance and returns
4. Being alert to red flags like promises of unusually high or consistent returns

Recap of Key Ideas

1. Separate Your Adviser from Your Assets: Use a custodian to create a buffer between your money and your financial adviser.

2. Be Wary of Consistently High Returns: Unrealistic promises and suspiciously smooth performance are red flags.

3. Demand Clear Explanations of Investment Strategies: Your adviser should be able to explain their approach in simple terms.

4. Don't Be Fooled by Exclusivity or Flashy Displays: Focus on substance rather than marketing tactics or ostentatious wealth.

5. Don't Trust Advisers Based on Charity Work or Reputation Alone: Look beyond surface impressions and verify claims.

6. Don't Rely Solely on Friend Recommendations or Shared Affiliations: Conduct your own research and due diligence.

7. Understand the Limits of SEC Protection: While the SEC provides oversight, ultimate responsibility lies with the investor.

Final Thoughts

"How to Smell a Rat" by Ken Fisher is an essential guide for anyone looking to protect their investments from fraud and mismanagement. By understanding the tactics used by financial predators and learning to recognize the warning signs, readers can make more informed decisions about their financial future.

Fisher's advice emphasizes the importance of personal responsibility in managing one's investments. While regulatory bodies like the SEC play a crucial role, they can't catch every fraudster or prevent every scam. It's up to individual investors to educate themselves, ask the right questions, and remain vigilant.

The book's lessons are particularly relevant in an era of increasing financial complexity and high-profile fraud cases. By following Fisher's guidance, readers can:

1. Better evaluate potential financial advisers
2. Understand the strategies being used to invest their money
3. Recognize red flags that might indicate fraud or mismanagement
4. Take a more active role in protecting their financial future

Ultimately, "How to Smell a Rat" empowers readers to take control of their financial lives. By learning to spot the signs of potential fraud and understanding the importance of due diligence, investors can significantly reduce their risk of falling victim to financial predators.

The book serves as a reminder that in the world of finance, if something seems too good to be true, it probably is. By maintaining a healthy skepticism, asking tough questions, and being willing to walk away from deals that don't feel right, investors can protect themselves and their hard-earned money.

Fisher's work is not just about avoiding fraud; it's about becoming a more informed and empowered investor. By understanding the tactics used by both legitimate advisers and fraudsters, readers can make better decisions about who to trust with their money and how to structure their investments for long-term success.

In a world where financial fraud continues to evolve and adapt, the lessons in "How to Smell a Rat" provide a valuable framework for ongoing vigilance. By internalizing these lessons and applying them consistently, readers can navigate the complex world of investing with greater confidence and security.