Ep. #16: How to Get Rich Part 4: Avoid Scams

There’s no sense working to gather money and invest it well if we’re only going to lose it to scammers and fraudsters. In this episode, we discuss three ways you can protect yourself from investment fraud that you may not have considered before.


Welcome to Rich & Thin™ Radio, the only podcast that helps you get more bank with less bulk. Today’s episode is part 4 of our series on how to achieve financial independence. I’m Kelly Hollingsworth, and I’m happy you’re here because now that we’ve talked about gathering cash, and investing cash, today we’re going to talk about how to protect it and keep it working for you instead of someone else.

Mostly when people, mainly lawyers, talk about asset protection they are talking about protecting your assets from a creditor. A creditor is someone to whom you owe money. So this kind of asset protection is about trying to find ways to avoid paying people to whom you own money.

That’s not what we’re talking about today. We’re going to talk about how you can protect the money that is legitimately yours–that no one else has a claim to. The first way you can do it is you set yourself up to avoid theft wherever possible.

How to avoid investment theft

The typical way we think of theft is that we have physical cash in our possession and someone takes it—a pickpocket, or a mugger, or a burglar in our house. For most of us, this isn’t that big a risk because the amount of cash we carry is limited. Never do most of us expect to carry every cent we have around in cash in a duffel bag.

The bigger threat is theft by an investment manager we hire—someone who’s supposed to be growing our money or keeping an eye on it, but who instead is siphoning it off for their own use. In cases like these, we tend to use the word embezzlement, but that’s just a fancy word for theft. Pro athletes and celebrities notoriously suffer this problem, and that’s sad because it’s easily avoidable in many if not most cases.

If you read about the Bernie Madoff scandal, you know that he was a high-profile investment manager who is currently serving a 150-year sentence for running a $65 billion investment scam. His investors were giving him money to manage, and instead of investing or trading the money, he was stealing the money and using it to fund his lavish lifestyle. When the crime came to light, many of his investors lost their life savings. Retirees who thought they were set had to go back to work, and some committed suicide. So today I want to talk about how you can avoid things like this in your own life.

Regulators won’t protect you

An important thing to notice about the Madoff theft, and many other crimes of this type, is that he and his companies were regulated. The SEC failed to detect this decades-long crime even though concerned citizens were writing in to the SEC and saying, “Hey, it looks like this whole thing is a massive fraud. You guys should check into it.” The SEC did check in to it, but they didn’t find it, and as a former financial services regulator, I’d like to tell you that this is not an aberration.

If someone is willing to lie, to dummy up documents and shuffle things around to make everything appear on the up-and-up, they’re a formidable opponent to all but the most seasoned of fraud examiners. And most regulators are not seasoned. They’re fairly young, often inexperienced, and they’re no match for someone like Bernie Madoff. He could run circles around them, and he did.

Regulators will tell you that before you make an investment, you should check and see if the company or manager you’re considering with is registered with the appropriate regulatory body. It could be the SEC, or maybe it’s the Commodity Futures Trading Commission or CFTC, but in any case, whatever regulator is applicable, what does “registered” mean? It means that the person you’re considering doing business with has put their name on a list maintained by the regulator. Maybe they had to pay some money or take a test or file some forms to get on the list, but once they’re on the list–bam, you’re registered. Being registered means you’re on the list and you’ve agreed to comply with some rules. That doesn’t mean you ARE complying with the rules, and there’s nothing magical about being on the list that will prevent that person from stealing from you. So just keep this in mind: you are your first, best, and most important line of defense.

The best thing a regulator can do for you, and it isn’t much, Is show up after the problems have already happened. The money’s gone, and then they’re on the case. Regulators don’t prevent problems and in this respect they don‘t protect you. You have to protect yourself. So how can you protect yourself from someone like Bernie Madoff stealing your money?

Keep your money in your own wallet wherever possible, even when investing.

The investment world can seem so confusing and complicated, so to start off let’s look at a totally non-confusing example. Let’s say you go to the ATM and withdraw $500 because you’re taking some extended family out to dinner later, and the restaurant only accepts cash. If this was your situation, how would you conduct yourself with that cash?

The first thing you’d do is keep the money in your possession. You’d fold it up and put it in your wallet for when you needed it. You wouldn’t give it to someone else to carry—it’s your cash and you’re the one buying dinner.

Then imagine you get to the restaurant and there’s a line out the door. One of the teenagers in the group offers to run across the street and get some lemonade for everyone while you all wait for a table. Would you give the kid the entire $500 for this venture? No. You’d peel off a twenty or two, and send him on his way. The rest would go back in your wallet.

Wherever possible, this is how I want you to think about your investing life. You keep all money in your possession, unless it’s absolutely necessary to hand it off to someone else to accomplish a specific purpose that you’ve delegated to that person.

So now let’s imagine a few scenarios so you can see how this idea would play out in the real world.

Here’s our first scenario. You have a next-door-neighbor who appears to be doing really well. He doesn’t go to work. His wife doesn’t work. He appears to spend most of his time in sweatpants. He takes a few hours in the afternoon to go to the gym, but that’s it. There is no evidence of employment or any kind of business coming out of this house, but there’s obviously money. There are nice cars, they take some nice vacations, they dress well when they’re not in sweatpants. It looks like everything is going financially really well over there. So what’s the story?

And one day your curiosity gets the better of you, and you ask him, “Don’t you work?” And he laughs and tells you that he trades. He trades stocks or cattle or oil or something else– what he trades doesn’t matter, the important thing is that he’s communicating to you that he has some special skill or knowledge and that allows him to buy and sell something for a few hours of the day and enjoy a nice income and a nice life.

And you get to know this guy. You become friends. Your families socialize together. And eventually you start asking yourself, I wonder if I can get in on this? I wonder if he can trade for me too? I would pay him a portion of my profits, even, if he would do this for me.

Now, you’re in a place of tension here, aren’t you? It looks like an opportunity, it smells like an opportunity. If the depiction, if the painted picture of this life your next-door-neighbor is living, is accurate, then it is an opportunity. I’ve invested with people like this, a person like this hypothetical next-door neighbor who has some special skill and makes his living in this way, and those are the best investments I’ve ever made. My husband has also made these investments, and he’s been very happy with them, too.

But when something like this comes up, it also sounds a little bit like it could be a scam. We hear all the time, “if it looks too good to be true, it probably is.”

So what do you do? How do you avail yourself of potential opportunities like this but still protect yourself from someone stealing your money?

A primary way you do this is you access their skill, you do hire them to trade or invest for you (after some due diligence which we’re going to get to in a minute), but you do this without giving them your money.

Here’s how you do this. Let’s say they tell you that they trade or invest in stocks. When someone does this, how exactly does that happen? What is the mechanism? They have a brokerage account and they deposit money into it, and then they place orders, usually they place the orders electronically but maybe they call someone at the brokerage firm, and these orders are to buy and sell stocks.

So if you want to trade stocks, there must be a brokerage account. So if you want him to do for you, with your money, what he does for himself, your money needs to be in a brokerage account. You can’t buy or sell publicly traded stocks without a brokerage account.

So now you’re at a fork in the road. Whose brokerage account are you going to use? Are you going to give him your money and he’s going to put it in his brokerage account? If you do this, if you give him custody of your cash, and he decides not to give the money back to you, to use it to fund his own lifestyle like Bernie Madoff did, then you’re in trouble. You’re in the same boat as all the Madoff investors who lost all that money.

The better thing to do is don’t put the money into his brokerage account. Open up your own brokerage account, in your name, and put the money in there. This is the equivalent of keeping the $500 bucks in your own wallet. Then you just give him the authority to trade in your account.

If you do it this way, he never has access to your money, but you have access to his skill.

Where did the Madoff investors go wrong?  The first place they went wrong is there was no independent brokerage firm. Bernie Madoff wasn’t just the guy with the skill who was doing the trading, the buying and selling and trying to make money. He also took possession of the money. If there’d been an independent brokerage firm holding the cash that Madoff was managing, he wouldn’t have had access to steal it, and that would’ve gone a long way to protect the Madoff investors from theft. Your brokerage firm holding an account in your name isn’t going to give your next-door neighbor unfettered access to your cash to use it to make his car payments and his house payments or go on safari in Africa.

This  idea of not giving up possession of your cash works in other scenarios as well. I often think about this for real estate investors. If you hire a management company to collect the rents from your tenants, and they then deduct their fee and pay you what’s left, there’s a risk that they’ll steal the money. Property management is rife with opportunities to embezzle–it happens all the time.  So to protect yourself, you can have all tenants deposit rent directly into your account, and then pay a portion to your property manager for their fees and also what they need to cover repairs and other expenses.

Similarly, authors, athletes, performers—basically anyone with an agent or a manager–also should think about this idea. The lion’s share of the money is coming to you, not to the agent or manager. So would the agent collect all the money, keep his percentage, and then pay the bulk of the money out to you?

This is standard operating procedure, but it’s risky, and it doesn’t make any sense, and it doesn’t have to be this way. The flow of funds can be negotiated so that the money goes into your accounts and not theirs.

Once you start looking out for this, you’ll see it everywhere. I once hired a law firm to do some work for me, and they wrote an agreement that when my money came in, it would be deposited into the law firm’s account and then the law firm would pay it to me. And I said no. None of that money was theirs. There was absolutely no reason for them to ever take possession of it. I had the agreement edited so the money was sent straight to me before I signed it.

Even my 401k is in my possession. It’s in a checking account that I sign on–no one else–and I direct the money to the investments I select. There’s no custodian, so there’s no risk of accounting shenanigans or fraud by someone else holding my money and sending me a phony statement when really they’ve stolen the cash.

So that’s my first tip for you, in terms of asset protection—if you don’t want someone to walk off with your money, keep it in your own wallet wherever possible. Don’t hand it off to another person unless doing so is critical to accomplishing the deal. If you don’t want to walk across the street and buy the lemonade yourself, you may need to hand some money to the teenager is going to go do. But even then, maybe not. You could send the money directly to the lemonade vendor, and just have the kid go pick it up.

I’ve given you a lot of examples about this, and it’s because I want you see that there are many, many instances where you will be asked to take cash out of your wallet and put it in someone else’s possession, when doing so is not necessary to accomplish the objectives and greatly increases your risk. If you open up your eyes to this, you will begin seeing it, and that is the first step to protecting yourself and your investments.

Insist on independent reporting

The second thing you can do that I’d like to discuss today is to be wary of anyone who writes their own report card. This was another problem with the Madoff crime that allowed it to go undetected for so long. Bernie Madoff was the guy who was supposed to be investing the money for his clients, and he also was the guy who was sending them reports on how well he was doing.

When you think about it, this is pretty crazy. If your second-grader came home with a report card that was scribbled in crayon, or your teenager came home with SAT scores in his own handwriting, would you question those? Of course you would. But the Madoff investors got glowing reports from Madoff about how much money he was making for them, and no one batted an eye about this.

This is something to avoid, in investments and in business, too. You always want a separation of duties.

We’ve already talked about how the regulators aren’t going to protect you from investment scams. They only come in to clean them up after the fact. Similarly, you shouldn’t look to auditors, the independent CPAs who come in at year-end to look at the books, to protect you. Even when an auditor is on the up-and-up, and in Madoff’s case the auditor was on the take and was sentenced to house arrest, an auditor’s job is not to detect fraud. People will tell you that this is safe because it’s been audited, but if you look at the opinions that auditors issue, if you look at their audit reports that they write when they’re done auditing a company or an investment fund, you’ll see that they explicitly say that audits are not designed to detect fraud. So don’t get complacent. If someone wants to lie to you and tell you that they are doing terrific things with your money when they are not, when really they’re stealing it or losing money, a CPA who comes in at year-end is not going to help you with that.

What you should insist on is an independent person who’s assessing the performance and sending you an independent report. If you hired your next-door-neighbor in the example we gave earlier, and put the money into your own brokerage account, every day, and at the end of the month, you would get directly from that brokerage firm a statement that says how your account is performing– whether there are profits, or whether there are losses. That’s an example of independent reporting. Unless your next-door-neighbor is in cahoots with that brokerage firm, which would be pretty rare and difficult to do, you have a much better assurance that you’re not being scammed like Bernie Madoff scammed his investors.

What are some other places where you can put independent reporting into place? If you have a business partner, or maybe you just invest in a business, someone else is running the business and you put up the cash, that person should not be the person who is reporting to you on how well that business is doing. There should be an independent person, doesn’t have to be expensive, it can just be a bookkeeper who you hire and who reports directly to you, who keeps track of the accounts and prepares the accounting entries and the financial statements for you to review. This separation of duties, independent reporting, will go a long way to protecting you, and in most investment scams, and most business scams where someone else just walks off with your money, there’s nothing like this in place. The student is writing his own report card, and that is a recipe for misreporting and misrepresentation and theft.

If the Madoff investors had had independent reporting, if they had insisted on it, that also would have prevented them from suffering the losses that they suffered. And here I’m not blaming them. A lot of the press coverage of the Madoff investors has called them greedy–they got what they deserved because they were so greedy to invest all their money with Madoff in the first place. There’s nothing greedy about wanting to invest well and make your money grow more money. We would never call a farmer greedy for wanting to grow the best, most prolific plants possible. That’s all these folks—the Madoff investors–were trying to do. Grow the best money tree possible. They just didn’t know how to protect themselves from scams like the one Bernie Madoff was running.

Now you do. Maybe you don’t know everything, but this is a good start. Taking ownership of your money, and of your responsibility to protect it from theft and misuse, will open up your eyes to how to protect it. The regulators and the auditors are not going to do this for you, and sometimes it seems a little scary, it can all seem super complicated. But investment scams typically happen in just a few different ways and most of them are easily preventable. They can steal your money. Usually this means that you gave them access to it or even possession of it, you handed it to them to put in their wallet, and they just didn’t give it back. A second thing they can do is lie to you about how well it’s performing, and you can go a long way to preventing this with an independent reporting mechanism.

Another thing they typically do is lie to you about their skill. So that’s the last thing I want to cover today. How you can do some due diligence before you pull the trigger on an investment manager or a business partner so you don’t wind up handing money off to someone who says they’re an expert but who really has no idea what they’re doing.

Do your own due diligence

Let’s go back to our discussion of your hypothetical next-door-neighbor. He says he’s living off the trading that he’s doing in his own account. Before you give him your money to trade for you, you should verify the performance of his account to see what it looks like. Is he really as good as he says he is? Or is his lifestyle really funded by his wife’s parents who set up trust to support her and her husband who talks a good game but really can’t trade his way out of a paper bag?

As with everything else we’ve discussed today, doing this independent verification seems obvious, but rarely is it done. We don’t want to offend the other person. We don’t want to seem untrusting. But here’s the thing: in the investing world, track record verification is common. People expect it and it’s no big deal. Institutional investors routinely do it because they don’t take statements of skill at face value—they verify everything.

Now, you may be thinking, I’m not an institution. I can’t do that kind of thing. I wouldn’t know where to start. I’d have to hire someone to look at that for me.

To this, I would say that hiring someone wouldn’t be preposterous. Few of us would buy a house without an inspection. Why do we routinely buy investments or hire investment managers without kicking the tires and seeing if what they’re saying about their skill actually shows up on paper? Too many reasons to count, but we’re running out of time for today, so suffice it to say that this is something we should consider doing beyond our real estate investments. Inspections are smart in any context. If we’re going to hand off our money to someone to manage for us, we should first look for a verifiable track record that indicates that they know what they’re doing and they’re not just feeding us a line.

So that’s what I have for you today, and this concludes our four-part series on how to get rich. If you enjoyed this series I sincerely hope that you will share it with a friend and I would also love it if you would leave a rating or review of the podcast on iTunes or wherever else you listen to podcasts. They really do help the show and in getting the message out to others. And with that I want to say thank you so much for joining me today I since clearly appreciate having you as a listener, and I am looking forward to connecting with you next time.

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