4 Ways to Avoid a Financial Scam: Don't Get "Madoff-ed"

(MoneyWatch)  My last post about Madoff's 150-year sentence aroused quite a response and requires that I clear the air about some issues that were raised:

• I don't think Madoff is worse than a murderer or a rapist
• Madoff is not the scapegoat for the entire financial melt-down -- there are no shortage of villains in this chapter of the American financial system
• While many Madoff victims were the super-wealthy, many were not. Let's not forget that charities have been forced to close as a result of Madoff
• I consulted a with a couple of psychologists/psychiatrists who concurred that "sociopath" is a fairly accurate term to describe Madoff

Phew -- with that said, let's address a common complaint about the Madoff victims: they should have known better. This is a fair statement, because greed is a necessary component of every Ponzi scheme. But come on all you judgmental people -- you get how this happens, right? Everyone is sanctimonious in the aftermath of a bubble. It makes me wonder: if everyone was so responsible, how did we get into this mess?

Yesterday, on WCBS-TV, I went through some of the warning signs that investors should look for to avoid being "Madoff-ed". They include:

1. Reluctance to discuss investment strategy. Madoff was known to tell would-be investors that he couldn't disclose any of his strategies because it was proprietary information. Financial advisers don't have to disclose every trade they have ever made, but they should present you with an investment policy statement and should encourage you to fully understand the strategy employed.
2. Control of all aspects of the investment process. When hiring a financial adviser, there are three distinct pieces of the process: the advice, the trading and the custodianship. In Madoff's case, he owned all three pieces, but in most firms, at least one of the pieces is handled separately, allowing for a third-party to conduct checks and balances.
3. Use of an unknown auditor . Ask the adviser for the name of the auditing company and ask your own CPA or friends in town if they have ever heard of the firm and/or know of the auditor's reputation. It was curious that Madoff ran a seemingly large business, yet the auditors were a small-time outfit that virtually nobody had known about.
4. Be cynical about stellar returns in every type of market. It may seem crazy to question returns, but one huge, red flag of the Madoff scheme is that he never had a losing month and his returns were consistent to the point of being manufactured.

If deep down you think that there could be a problem, you can always seek a second opinion from another adviser. Or you can just trust your gut and move on to another firm.