This is a repost of an excellent article by Christine Benz that was published in Morningstar entitled Seniors: Beware of Affinity Fraud:
In hindsight, a scam like the one Bernie Madoff perpetrated on his victims looks like it should’ve been a cinch to detect. Madoff’s clients were promised steady returns of 10%-12% per year; that should’ve looked impossible even to novice investors, particularly given the extreme market volatility that marked the first decade of the 21st century. Financial analyst and Madoff whistle-blower Harry Markopolos said he knew that Madoff had faked his clients’ returns within five minutes of seeing them.
Much ink has been spilled over how Madoff managed such a swindle–a court-appointed trustee estimated client losses in the $18 billion range–but one of his methods was clear: Using a technique called affinity fraud, Madoff presented himself as a trusted member of communities at the same time he was trying to separate them from their money. Various Jewish organizations and institutions, as well as Jewish individuals planning for their own financial goals, were hit particularly hard: In addition to losing millions, several charitable entities were forced to lay off staff or close altogether.
Although the scale of Madoff’s abuses is unparalleled in modern U.S. financial history, affinity fraud is far from uncommon. Even before Madoff’s crimes came to light, an SEC investor alert ticked off a broad swath of groups that have been targets of such frauds, including Jehovah’s Witnesses, Baptists, African-Americans, and Hispanic-Americans. In addition to targeting specific religious, ethnic, and socioeconomic groups, many such frauds have also revolved around seniors. It’s easy to guess why the senior population has been vulnerable: Not only do financial decision-making abilities tend to decline as people age, but financially strapped seniors might be particularly receptive to finding someone they can trust to make their money last and grow.
Although you might think you’d be able to spot the next Madoff from a mile away, each instance of affinity fraud is slightly different, so it’s important to stay vigilant and not derive a false sense of comfort if someone in your social or religious network is pitching you on an investment. Take the following steps to protect yourself before entering into any such transaction.
Don’t Just Take Their Word for It
To navigate a complicated world, it’s only natural to seek guidance from those around us. This is true whether the decision is relatively trivial, such as a restaurant choice, or more serious, such as selecting a school for the kids. But when it comes to financial decision-making, it’s essential that your research process doesn’t begin and end with a friend’s advice, as is often the case in instances of affinity fraud.
Be on high alert if someone is pitching you on a product type that isn’t publicly traded, as such investments are subject to much less stringent regulatory oversight and disclosure requirements than are stocks, bonds, mutual funds, and exchange-traded funds. (This article discusses some specific nonpublic investments of which to be wary.) If you’re hiring an advisor, look for a person who has earned the CFP designation and is required to act as a fiduciary, meaning that he has to put your interests before his own. This SEC memo provides tips for checking out investment advisors and includes links to websites where you can find more information on advisors and check up on brokers’ regulatory histories.
Don’t Derive a False Sense of Security From Supporting Materials
If you’re looking for corroboration that a person or product is on the up and up, the availability of printed materials, a website, or an 800 number might seem to provide the confirmation you seek. But don’t derive a false sense of security from them. Although it’s true that fraud perpetrators might be hesitant to leave a paper (or Web) trail for their scams, it can be easy to create fake materials or set up a phone line for a sham business. Proceed with extreme caution (or better yet, don’t proceed at all) if you can’t find reliable third-party information about the product, advisor, or firm.
Make Sure You Have a Sounding Board
The field of behavioral finance has demonstrated that once we humans have a thesis about something, we look for data that corroborates that viewpoint, when in fact we should do just the opposite. To help work against that natural tendency, all investors should have a sounding board for new ideas–a financially literate investment buddy who can play devil’s advocate and help ensure that you’re asking the right questions before jumping into an investment. Your sounding board can be an investment-savvy son or daughter, a trusted family member, or a professional financial advisor. All seniors should be thinking about succession planning for their investments in case they become disabled or die, and it’s worthwhile to loop that person into any big changes you’re making to your investment plan.
Beware of Outliers
Just as Madoff’s history of stable and high returns in very volatile markets should’ve been a tip-off that not everything was on the up and up, investors should be on high alert when a product purports to deliver returns that are substantially better than those of competing products. Although such returns might not necessarily be faked, at a minimum they’re a red flag that the investment could harbor risks that haven’t yet risen to the surface. And be prepared to run the other way if the investment is being touted as having both high returns and low or no risk; that’s a tough combination for an investment to deliver in any market environment, but especially so right now, given the low yields available on truly safe securities.