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Moral of the Madoff scandal: Check out financial advisors

Few investment mistakes can be as crippling to your long-term wealth as entrusting your nest egg to a crook.

January 25, 2009|Kathy M. Kristof

Even if your portfolio is way down, you may be patting yourself on the back: At least you didn't invest with Bernie Madoff.

Brilliant investors bought into his alleged $50-billion Ponzi scheme, but not you.

Well, don't get cocky (and not only because you probably never had the opportunity to give your money to Madoff).

The sad truth is that the danger of investment scams is ever-present. Since Madoff's arrest, securities regulators have charged a half-dozen other financial advisors in similar, though much smaller, alleged schemes, including Florida hedge fund manager Arthur Nadel, who allegedly took off with $300 million.

Ponzi schemes are so common that most of them don't even make the news.

But the losses are real and devastating whether you're caught up in a billion-dollar scam or a million-dollar one.

Indeed, there are few investment mistakes that can be as crippling to your long-term wealth as entrusting your nest egg to a crook.

"If you buy a basket of stocks, even if one of them ends up being Enron, you will only lose a small portion of your investments," said Chuck Jaffe, author of "The Right Way to Hire Financial Help." "If you invest with a scoundrel, you will lose everything."

The moral of the Madoff scandal is that you need to give any financial advisor you hire a proper vetting and monitor your investments regularly.

Here's a five-step process to protect yourself against the next Ponzi scheme.

Step 1 -- Get referrals: Ask friends and relatives if they have financial advisors they'd recommend, but use them only to narrow the field. Too often, investors get hurt because they get a name from someone they trust and then let their guard down, Jaffe said.

Step 2 -- Check 'em out: Your prospective advisor should come clean on all three of these regulatory checks:

* Ask your state. Regulators in each state maintain records of sanctions and lawsuits against financial advisors. To find your state securities regulator, go to the website of the North American Securities Administrators Assn. at nasaa.org and click on "Contact Your Regulator."

* Check with FINRA. The Financial Industry Regulatory Authority at finra.org maintains a national database that can be particularly helpful with advisors who move from state to state, wreaking havoc wherever they go.

* Form ADV. Every financial advisor must file a form ADV with the Securities and Exchange Commission. Advisors are required to give Part II of the form to anyone who asks. But Part I has the advisor's complaint history. Ask for both parts, Jaffe advises.

You also can get Part I via the SEC's site at www.sec.gov. Click on "Check Out Brokers and Advisers" and then click on "Investment Adviser Public Disclosure."

Any hint of trouble with any of these checks -- including an advisor's reluctance to provide both parts of form ADV -- should automatically disqualify the advisor, Jaffe said.

Step 3 -- Insist on a plan: Madoff's alleged victims were so blinded by his purported returns that they failed to ask a crucial question: What's my plan?

Any financial advisor worth her salt will not invest your money without gathering detailed information about you -- your assets, your goals, the amount of time you have to reach those goals and your feelings about risk, said Marc Freedman, president of Freedman Financial in Peabody, Mass., and author of "Oversold and Underserved: A financial planner's guide to effectively serving the mass affluent."

With that information in hand, the advisor should suggest a mix of assets that can include stocks, bonds, international securities, cash, real estate and other securities. He should specify the percentage of assets to be invested in each investment category.

The advisor also should be able to say why any individual stock, bond or mutual fund is part of the portfolio. If she's reluctant to do so, or is vague or impatient when explaining the specifics, consider it a red flag, said Cindi Hill, a certified financial planner with Hill Financial Advisors in San Diego.

"If you are afraid to ask questions, you should have a different advisor," Hill said. "You have to feel comfortable raising concerns and asking questions."

Step 4 -- Monitor performance: Ask your advisor which market indexes he and you will use as benchmarks for your portfolio. For instance, the stock portion of your portfolio might be measured against the Standard & Poor's 500 index.

At least once a year, look at how each portion of your portfolio has done and compare that to the corresponding index, said Spencer Sherman, chief executive of Abacus Wealth Partners and author of "The Cure for Money Madness."

If you are well diversified, Sherman advises, the performance of each sector of your portfolio should be within spitting distance of the benchmark. If it isn't, consider that a red flag and ask for an explanation, even if you're outperforming the index, Sherman said.

If the performance is consistently well above the benchmark, it could be a sign of fraud.

Step 5 -- Verify: You want your advisor to use a custodian -- such as Fidelity Investments and Charles Schwab Corp. -- to handle trades and maintain customer assets. If your advisor, like Madoff, handles the trades, holds the assets and provides the investment statements, you have no independent verification that what he says he's doing with your money is actually being done.

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kathykristof24@gmail.com

Kathy Kristof is a personal-finance author and syndicated columnist.

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