How to Smell a Rat Summary

What would you do if you lost all the money you saved? This book shows you how to avoid falling victim to financial fraud.

1. Separate Custody and Investment Advice

When investing with an adviser, ensure custody and investment responsibilities are separate. Any overlap between these roles can lead to misuse of client funds. A custodian safeguards your assets, while an adviser manages investment decisions. This arrangement prevents fraudulent activity by introducing an independent layer of oversight.

If your financial adviser has full access to your funds without a third-party custodian, this creates an opportunity for them to manipulate records, embezzle money, or issue false statements without independent verification. Independent custodians provide statements you can cross-check with what your adviser shares, reducing chances of fraudulent behavior.

Putting safeguards in place also allows you to monitor your investments 24/7. This transparency ensures no unauthorized withdrawals or unexpected investment changes occur without your consent.

Examples

• Bernie Madoff acted as both adviser and custodian, enabling his $65 billion Ponzi scheme.
• Independent custodians ensure every withdrawal or trade is approved by the client.
• Using a reputable financial institution for custodial services adds a layer of protection against fraudulent activities.

2. Be Wary of Unusually Consistent Returns

No adviser can guarantee consistent, above-average returns year after year, particularly during market downturns. Successful investment strategies naturally experience highs and lows because financial markets fluctuate.

If an adviser promises you consistently strong returns or exorbitantly high percentages, consider this a red flag. Volatility in the market means genuine performance will vary over time. Even the best money managers, such as Warren Buffett, have years where they underperform.

Data from Global Financial Data shows that most annual returns in the S&P 500 since 1926 are either below zero or above 20%. During events like the 2008 recession, no legitimate fund manager could report equal success compared to previous stable years.

Examples

• Fraudsters like Nicholas Cosmo and Charles Ponzi promised guaranteed returns of 40-50%.
• Even Warren Buffett has had years with underwhelming results, proving no one beats the market consistently.
• During the 2008 recession, Madoff’s consistent returns were a glaring anomaly.

3. Effective Communication in Plain Terms Matters

An adviser unwilling or unable to explain investment strategies in simple terms should set off alarm bells. Complex jargon is often used to obscure fraudulent intentions or highlight confusion.

Every investor deserves to understand the investment plan and how their money will grow. If your adviser talks in circles or hides behind vague “proprietary tactics,” this could signify deception or inexperience. True professionals educate their clients.

Separating strategy from tactics is another test. Tactics are the tools of investment (e.g., derivatives), but strategy is the overall plan. Beware of advisers who only discuss flashy tactics without a clear plan.

Examples

• Bernie Madoff marketed “split-strike conversions,” but most investors were left in the dark about what it entailed.
• A solid investment adviser clearly explains both the overarching strategy and individual tactics used.
• Plain-language communication allows clients to make informed decisions about their finances.

4. Distrust Flashy Exclusivity and Opulence

Exclusivity and lavish appearances are often used to create an illusion of trust and professionalism. Being invited by a personal reference to an “exclusive” investment opportunity might seem appealing but could also be a well-engineered trap.

Opulence, like luxury office decor or high-end lifestyles, doesn't mean an adviser is trustworthy or effective. In reality, these costs are likely funded by client fees. Focus instead on the adviser’s performance history and transparency.

Bernie Madoff’s exclusivity came with a hefty price: many were blindsided by his manipulative tactics, mistaking prestige for trustworthiness.

Examples

• Madoff invited select investors, fostering an aura of exclusivity.
• An adviser with lavish expenses might risk client money for their personal benefits.
• The best advisers prioritize client interests over luxurious personal displays.

5. Charitable Giving Doesn’t Equal Integrity

Donations to charity or good reputation don’t guarantee a trustworthy financial adviser. Fraudsters often use philanthropy to distract from their true intentions, gaining public favor while engaging in misdeeds.

Madoff donated extensively to nonprofits, which helped deepen public trust in him. Allen Stanford, another notable fraudster, aligned with anti-fraud initiatives to conceal his bad behavior. Generous giving doesn’t excuse or prevent unethical practices in financial management.

Trust must be based on tangible evidence of an adviser’s legitimacy, not their image or charitable precedence.

Examples

• Madoff donated over $1 million to the Lymphoma Research Foundation.
• Stanford supported anti-fraud legislative efforts to mask his schemes.
• Fraudsters use charitable acts as shields to enhance credibility.

6. Friend Referrals Aren’t Enough

A recommendation from a friend is a starting point but should never replace thorough vetting of an adviser’s credentials. Friends might be unaware of what makes a trustworthy adviser or could unknowingly refer you to a scam.

Fraudsters exploit the trustworthiness of social networks to hook new victims. Madoff leveraged his Jewish community connections to find new clients, bankrupting individuals and charities.

Look beyond personal connections and thoroughly research an adviser’s background, qualifications, and investment methods.

Examples

• Madoff’s referral system preyed on close-knit communities for credibility.
• Friends may select advisers based on convenience, not careful vetting.
• A rigorous screening process helps ensure your adviser is legitimate.

7. Understand the Role and Limitations of the SEC

While the SEC works to protect investors through transparency and oversight, it isn’t foolproof or omnipresent. Fraudsters often slip through regulatory gaps or provide misleading registration information.

For instance, Allen Stanford omitted his past bankruptcy from SEC records by manipulating his registration classification. The SEC also lacks the resources to thoroughly investigate every firm in real-time.

Ultimately, while the SEC sets regulations, individual investors must perform their own due diligence to avoid risk.

Examples

• Stanford’s incomplete registration omitted suspicious financial history.
• Surprise audits by the SEC don’t cover all documents, leaving gaps.
• Form ADV requires disclosures, but investors must review them closely.

8. Beware of “Free” Advisory Services

An adviser offering free services might still be getting paid indirectly, such as earning commissions from companies whose products they recommend. This creates a conflict of interest between your needs and theirs.

Madoff charged clients only transaction costs, luring them into a false sense of security while profiting through other deceitful means. True transparency around compensation is essential to building trust between adviser and investor.

Always ask your adviser to disclose their compensation model and motivations.

Examples

• Madoff profited while advertising “low fees” to clients.
• Hidden commissions can undermine an investor’s portfolio performance.
• A clear fee structure reduces the risk of unexpected conflicts.

9. Trust Emotionally Neutral, Analytical Processes

Investments should never be based on personal affiliations or emotions alone. Trusting an adviser simply because they share your social circle or belong to the same organization is a mistake.

Fraudsters exploit such affiliations to build unwarranted trust. Madoff used his Jewish community connections while others exploit alumni networks or religious institutions.

Instead, analyze facts, performance metrics, and contracts objectively to identify real credibility.

Examples

• Madoff exploited his Jewish community ties to build trust and expand his Ponzi scheme.
• Peer group members are often biased in trusting their own.
• Professionalism, not personal ties, should drive investment decisions.

Takeaways

1. Use an independent custodian to safeguard assets and cross-check financial statements.
2. Always perform due diligence, even when referred by a friend or peer.
3. Require full transparency on fees, investment tactics, and strategies before investing.