Safeguard #2: Walk Away from "Too Good to Be True"

The following is a guest post from Marotta Asset Management.

In addition to the all-important fiduciary requirement, you should insist on several other investment safeguards. Safeguard #1: Do not allow your financial advisor to have custody of your investments. The second safeguard: Avoid any investment opportunity that sounds too good to be true.

I learned this principle in a practical way from my father when I was 13 years old. One of my brothers had a friend whose father was doubling his money in an investment company that was importing Portuguese wine. They were selling it for more than twice what they had paid for it and making money hand over fist.

But they needed cash to buy the wine. After having the wine shipped from Portugal and distributing it around the Washington, D.C., area, they were paying 50% interest. Because orders had already been taken, it was touted as a sure thing. My father, George Marotta, was asked to invest in the next shipment.

His response was right to the point. He just said, "It sounds too good to be true." That was it. No looking into the matter, trying to determine where the catch was. He simply refused to waste his time on it.

My brother wanted to take the money my parents had saved for him and invest it in the Portuguese wine deal. Why not, he reasoned. It was guaranteed, wasn't it?

Again my father refused to allow my brother to invest anything. He explained that they couldn't be making 50% interest every six months. There had to be a hidden difficulty or complication.

Six weeks later the scandal broke on the front page of the Washington Post. There was no wine. Families lost their life savings and their children's college funds. It was all a Ponzi scheme. They were paying early investors with the money taken in by subsequent investors. Without any real returns, all Ponzi schemes eventually run their course and then implode.

Nothing really changes. For many people, greed can block common sense. This natural but deadly impulse is one you must learn to overcome.

Shortly after my father's wisdom was vindicated, it was suggested he give his sons some practical experience in investing by finding a good pick for us, some penny stock that was going to two pennies without very much risk.

My father again replied wisely, "If I knew a penny stock that was going to two pennies without any risk, I would invest our life savings and double our money. Such an investment doesn't exist."

Here's the hard lesson: There is no such thing as a sure thing, and if something sounds too good to be true, it is.

I used to analyze offers to find the proverbial catch. I would scrutinize the small print and find where they were going to make their money. Curiosity drove me to know, and in the process I learned a great deal about the dishonest methods companies use to separate fools from their money: bait and switch, allure of exclusivity, guarantee or your money back, limited time horizon and automatic charges.

And then there were the handful that really sounded too good to be true. And it struck me that they were blatantly lying. Nothing could be found in their literature to determine where the snag was because they simply were not telling the truth. And that is part of the lesson to be learned. You don't need to know where and how they are lying. But if it sounds too good to be true, it probably is.

Madoff Securities was recently caught in the largest Ponzi scheme in history. For years, Bernie Madoff collected assets with returns that seemed amazing. Hedge funds fronted for his investments, putting their own private label on his $50 billion scam.

Madoff was known as the guy who never seemed to lose money. It was implied he was subsidizing down months in the markets, a common rationale around Ponzi schemes. There has to be some reason given in a Ponzi scheme for the total lack of volatility, and the rationale commonly offered is that the company eats its losses during down months.

But it is a securities fraud to misrepresent either an investment's returns or the volatility of those returns. We are always reminding our clients and our readers that the markets are inherently volatile. Despite this tendency, they have also been profitable, even taking into account the significant drop in 2008. You should expect to see and understand the risk you are taking. Don't be mesmerized either by the promise of a high return or a sure thing. Even Treasury bills carry the inherent risk that you will lose your buying power to inflation.

Although the preceding may sound cynical and paranoid, many posing as financial advisors really do try to separate you from your money. Fortunately, only a few do it fraudulently. Others may do it legally in small amounts through hidden fees over a long period of time. Both may be actively calculating how to maximize their portion and minimize yours and how to hide how much they are keeping and the real return you are receiving.

So the challenge for investors seeking financial advice is clear. Where is the moral high ground? How can investors avoid as much as possible the conflict of interests inherent in many compensation schemes and find an advisor who simply helps clients meet their goals?

The National Association of Personal Financial Advisors, created in 1983, is an industry association of firms that provide independent financial advice. Their compensation is not clouded by the purchase or sale of a financial product.

You have a right to be proactive and ask the right questions. It is up to you to know how your advisor is compensated and how your investment return is calculated. And if past returns sound too good to be true, don't believe them. Visit http://www.napfa.org/tips_tools to learn more and become a truly savvy, and safe, investor.

Click here to read part 3 of this series.

Comments

[Zen City Chick]

I'm wary by nature so I'm always checking into things. I have yet to fall for a 'too good to be true' offer.

Great post.

[Sista-WAHMs]

Our dad always used to "burst our bubble" when we got excited about things that he knew were too good to be true but we had no clue on. Once in Jr. High School we bragged to him about having like 12 friends saying "dad we are so popular, everybody hangs out with us" and he without thinking twice or sugar coating it said "don't think cause all these people hang around you two means that you are popular, you are not...you don't need to be popular". He gave us a quick lesson that made good sense and we never forgot that "bubble bursting" moment or any of the others. As work at home moms we find other mothers who could benefit from having their "bubbles bursted" when it comes to finding work online. Many of the offers available out here are just flat out scams and too good to be true. Yet struggling moms put what little money they have into them ne-way. The same advice you gave for finding the moral high ground in financial investors is along the same lines we give for finding legitimate work from home jobs. There are many businesses online ready, willing, and able to help, a simple search on the net for legitimate work from home jobs and digging from there will give sound information. Sista-WAHMs gives this post two thumbs up. A post that is too good but absolutely true.

[Education Works]

The age-old statement, "If it sounds 'too good to be true' it usually is," can apply to numerous different industries although the article utilized a Ponzi scheme as an example. On a recent broadcast news commentary, the investigative reporter examined www.freecreditreport.com and exposed how its sale pitches, catchy commercials, and jingles mask the truth. Several times during the report, the reporter reminded views that individuals can accomplish essentially the same thing through www.annualcreditreport.com to monitor their own credit reports. For another example, heavy advertising to "refinance your higher interest rates into your mortgage and the interest might also be tax deductable." That bombardment of advertising not only RUINED many very good loan officers (as high as 37.5%) who LISTENED and ATTEMPTED to educate borrowers and potential borrowers about various other--and less risky--available options. Due to the constant bombardment, one mortgage brokerage finally decided that, if a borrower was unwilling to listen to WHY a cash-out refinance was NOT in this borrower's best LONG-TERM interest, the borrower's decision could possibly lead to eventual foreclosure. The truth is that, in MANY instances, the heavier or more frequent the advertisement stating how "good" a specific product or service is, the more likely the adage, "If it sounds too good to be true, it usually is" applies.

[kitty]

So true. Very good article and very interesting story about the wine.

An interesting thing about Madoff as well as the one that probably attracted otherwise intelligent people is that he wasn't offering spectacular returns. His returns were around 11% a year - something many funds provided as an average return over 10 year history at least until the recent crash. The key of course was "average" as opposed to year-after-year. The thing unusual about Madoff was his consistent return - in both good and bad years. But the fact that he wasn't offering 50% in 6 month but a "mere" 11% a year was what made supposedly savvy people like hedge fund managers believe him. They probably didn't think of his returns as "too good to be true". Even SEC looked the other way: as early as 1999 one hedge fund manager investigated Madoff's supposed strategy, determined it couldn't have possibly been true: not only a specific option trading strategy couldn't have achieved these returns, but at no point during the past years the number of PUTs and CALLs for specific companies was large enough to account for Madoff's investors. He decided it must be a Ponzi scheme and wrote to SEC about it. Nothing came out of it.

Madoff was also a family friend to many of his investor. That's I guess another moral - don't trust someone with your life savings just because it's a family friend.

[Mel]

Remember that commercial by Capital One, the credit card company with the catchy phrase, "What's in your wallet?" Well now you should ask "Whose in Your Wallet?" and if you don't know the answer you could end up with too much month at the end of the money.

[Bad Credit]

I think the problem is that most people are inherently looking honest and always looking for opportunities. When you put those same values to work on different dishonest people when you have a problem. That is where and when these dishonest people take your money from you.

[Jim]

Another good one from Marotta.

[Fidelity Select Fundranker]

I got an email a few days ago, supposedly from the CEO of NewLight Investments Co. He wanted to exchange links with me, but after looking at his site, I did not even respond. It definitely fits in the too-good-to-be-true category, if it's not an out-and-out scam. It's a really snazzy website, but the suggested returns and zero risk they advertise seem impossible. I am monitoring his website to make sure he does not link to my website, although I don't know quite what I will do if he does. If Marotta or FMF readers care to check out NewLight Investments, I'd be very interested in your reactions.

[Mark]

In response to the NewLight Investments site: It's not even a very good scam. It has no specifics whatsoever, numerous spelling mistakes, no "client testimonials", etc. I have seen better cons from the famous Nigerian 419 scams.

Maybe this is a test to see how stupid people are? Or maybe put up as an educational tool by a legitimate company to then reply to inquiries and explain why the respondent needs help. (Like the US government once put up a site and informed respondednts about ID theft.)

Or maybe it's simply a new way to distribute viruses.