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Chapter 17: Too Good To Be True

Chapter 17 image

“You’ve got to get in on this! This investment seems too good to be true!”

 

WARNING : Too good to be true nearly always is.

In my 2009 book, How to Smell a Rat, I wrote about the five signs of financial fraud. This was in the wake of the massive, billion-dollar, decades-long Madoff Ponzi fraud’s coming to light—made more tragic because it was easily avoidable. How so? The key decision maker was also the custodian—the number one sign a Ponzi is possible.

What does that mean? Madoff was responsible for deciding what to buy and sell and when for client portfolios. And clients deposited funds with Madoff Investment Securities. The fox was guarding the hen house.

Madoff founded Madoff Securities in 1960, and it was then and appears now to have always been a legit brokerage—it had been one of America’s biggest market-makers in both NYSE and NASDAQ securities. The brokerage firm wasn’t the problem—not on its own. The problem was Madoff controlled it and the hedge fund. Because Madoff controlled both the advisory and the custody sides, it was technically nothing for him to dummy up statements and take money out the backdoor—for years!

This is the basic structure for every financial Ponzi I’ve studied. Either the adviser and the custodian were ultimately under singular control, or the adviser had some form of influence over the custodian. And amazingly, in the tsunami of reporting that followed the Madoff and Stanford Ponzi scandals, none I saw focused on this key factor.

Separate Decision Maker and Custody

If you separate the two—insist your funds be held in a separate, well-known national custodian, where you deposit money yourself in an account in your own name (or yours and your spouse’s, or in your trust’s name, etc.)—you make a financial Ponzi scheme near-impossible.

Still, not every outfit that’s both adviser and custodian is sure to defraud you. I personally set my business up with the two functions separated to protect my clients from employees going rogue. Or from me going rogue! (There are some reports that Madoff didn’t start out intending to defraud. But he started faking account statements after normal market downside resulted in poor returns. Someone with such a fragile ego has no business managing money for other people.) But there are legitimate reasons an adviser may decide to also custody—an additional reason to be aware of the other four signs of potential financial fraud.

  1. Your adviser also has custody of your assets.
  2. Returns are consistently great! Almost too good to be true.
  3. The investing strategy isn’t understandable, is murky, flashy, or “too complicated” for him (her or it) to describe so you easily understand.
  4. Your adviser promotes benefits, like exclusivity, which don’t impact results.
  5. You didn’t do your own due diligence, but a trusted intermediary did.

You should do due diligence on any firm you hire. But a firm with one sign merits a deeper look. Be exceedingly wary if there are multiple. Better to be suspicious and safe than trusting and sorry.

And the idea that returns “too good to be true” may be valid can be particularly damaging.

High and Steady … and Fake

There are two basic camps here—either should make you skeptical. The first are eerily steady returns. This was Madoff’s game. Each and every year, he reported client returns of about 10% to 12%. Market up big? His returns were 10% to 12%. Market down big? Returns were still about 10% to 12%. Even month-to-month returns were steady.1 No big down months or years. A dream come true that was actually a nightmare—usually the case with too-good-to-be-true returns.

That steadiness is like a narcotic. It appeals to our caveman brains and makes us not question too hard—con artists hate getting questioned hard. But such steadiness should immediately be a red flag.

Why would 10% annual returns be alarming? After all, stocks have returned an annualized 10% over long periods.2 But that’s an average and, obviously, bakes in huge variability. Years when annual stock returns are around 10% are actually quite rare. Much more often they’re up big or down, as shown in Exhibit 7.1 in Chapter 7. Knowing this—accepting in their bones that stocks’ returns are naturally variable would have been an additional layer of protection for Madoff’s would-be victims—and many other victims of countless Ponzis over the years. Returns so steady aren’t just a deviation from reality—they’re an outright sign something may be drastically awry.

Now, that probably wouldn’t be true if the returns were low and steady. Sure, portfolios with lower shorter term volatility (i.e., a much smaller share of equities) can certainly feature less-variable annual returns. But that would mean returns wouldn’t be anything close to equities’ long-term average. And even a portfolio with heavy allocations of fixed income would have down years. It would require a portfolio heavily allocated to cash or near-cash instruments to have no negative annual returns—before you account for inflation.

A portfolio with long-term returns about matching equities’ long-term average should, on average, feature equity-like volatility. No way around it. Be exceedingly suspicious if someone sells you a portfolio with longterm equity-like returns with minimal volatility. Better yet, be out the door.

Super-High … and Also Fake

The second common Ponzi con tactic is promising huge, mega-outsized returns. The former tactic appeals to our natural dislike of volatility. The latter is about greed—pure and simple.

This was convicted-fraudster Sir Stanford’s game. His Antiguan-based bank sold $8 billion in CDs with impossibly high rates—at times topping 16%! Actual CDs from real banks were offering rates as much as half that.3 But other scamsters historically have done the same thing—guaranteeing huge, way-above-equity-like returns or otherwise unreasonably high returns given the underlying asset, often for very short-term investments. Double your money in three months! That sort of thing.

The red flags are many. Primarily, no one can legally guarantee you anything. Yes, Treasurys are guaranteed inasmuch as the principal and interest payments are backed by the full faith and credit of the US government. If you buy a Treasury and hold to maturity, the US government promises you’ll get your principal back with interest paid on time. But if you sell before maturity, you can lose money. (See Chapter 1.) Any investment guarantee from anyone other than the US government should be considered a scam.

Even annuities, which can come with guarantees because they’re insurance contracts, still feature a warning the annuity is only as good as the insurance firm is solvent. (For more on annuities and why they’re usually not a good alternative for investors seeking long-term growth, see Chapters 15 and 16 in my 2009 book, Debunkery.)

Too-good-to-be-true scams don’t just involve standard investment vehicles like stocks, bonds, CDs, etc. I can’t guarantee you anything because, again, no one can or should. But I can near-guarantee if someone approaches you with a can’t-lose investment with super-high guaranteed returns, it’s very likely a scam.

Scams of All Stripes

By now, hopefully, most readers are familiar with the “Nigerian” scam (also known as a 419 fraud—from the section of the Nigerian criminal code)—usually obvious, poorly worded appeals via email from someone claiming to be disgraced royalty who needs your help getting $25 million out of some war-torn nation. There are many derivatives, but know this: If someone asks you to forward them money to help them liberate a bigger chunk of money that they’ll share with you, it’s a scam.

Other scams aren’t so obvious—aside from the guarantee they can’t legally make for unrealistic returns. Like the Iraqi dinar scam. In this, victims are approached via email or Internet ads to buy Iraqi dinars. Huge returns are promised from the strengthening dinar. And there are legitimate exchanges if you have legitimate business in Iraqi. But most Internet dinar exchange solicitations are outright scams. And anyone promising you huge returns for arbitraging any currency exchange rates is probably a con artist.

Another popular scam in recent years is the ATM leaseback scam. Here, con artists offer to buy ATM machines on your behalf, and you lease them back to them. They manage them for you and promise you a guaranteed monthly stream of income. You can legitimately buy ATMs and manage them if you want. That’s not what this is, though. You know it’s a scam because they tell you they need $12,000 or more up front to buy the machine—real ones run much less, maybe between $2,000 to $5,000. And they also guarantee you a monthly profit, which, of course, they cannot do. You can go to the FBI’s fraud section to review current popular frauds to better arm yourself against con artists (www.fbi.gov/scams-safety/fraud).

No matter the scam, the con artist may lull marks into believing it’s legit by sending them monthly or quarterly checks—at first. Rarely a return on investment, this is more likely cash flow from newer incoming marks—classic pyramid style. They may try to keep initial victims happy because they can use them to help sell the con to future marks. Con artists often use victims to appeal to that victim’s social circle. Your friends, colleagues and/or church group may not know the con artist from Adam, but they know you! And trust you. And if you got a couple of checks and are happy, that’s a big vote of confidence in the fraudster. The fraudster may exploit that confidence to net more of your friends as victims. It’s a dirty game. The moral of the story? If it seems too good to be true, it probably is. That’s no myth.


Notes

  1. Alex Berenson, “Even Winners May Lose With Madoff,” New York Times, December 18, 2008.
  2. Global Financial Data, Inc., as of 07/10/2012; S&P 500 Total Return Index annualized returns from 12/31/1925 to 12/31/2011 is 9.7%. The S&P 500 Total Return Index is based upon GFD calculations of total returns before 1971. These are estimates by GFD to calculate the values of the S&P Composite before 1971 and are not official values. GFD used data from the Cowles Commission and from S&P itself to calculate total returns for the S&P Composite using the S&P Composite Price Index and dividend yields through 1970, official monthly numbers from 1971 to 1987 and official daily data from 1988 on.
  3. Securities and Exchange Commission v. Stanford International Bank, et.al., Case No. 3:09-cv-0298-N, filed 02/29/2009.

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This excerpt from Little Book of Market Myths is distributed by permission of Wiley & Sons and is subject to copyright laws and other restrictions imposed by the provider of the information.

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