How to Smell a Rat

1. Separate Decision Maker from Custody to Prevent Financial Fraud

"If the manager has custody, he can take money out the back door—any time he wants. Don't give any adviser that opportunity, no matter what."

Fundamental Fraud Prevention. The most critical step in protecting your investments is ensuring that the person making investment decisions does not have direct access to your assets. This separation creates a natural barrier against potential embezzlement and provides transparency in financial management.

Practical Implementation:

• Insist on a third-party, reputable custodian for your assets
• Ensure your account is in your name
• Verify that the decision maker cannot make withdrawals
• Choose a large, established financial institution for custody

Risk Mitigation. By maintaining a clear separation between investment decision-making and asset custody, you significantly reduce the opportunity for financial fraud. This approach creates a fundamental firewall that makes it much more difficult for potential fraudsters to misappropriate funds.

2. Beware of Returns That Seem Too Good to Be True

"Consistent returns year to year are suspicious, as are wildly above-average returns."

Performance Red Flags. Legitimate investment strategies inherently involve volatility. Consistently high, stable returns are often a sign of potential financial fraud. Real investments experience ups and downs, and any claim of perpetual positive performance should raise immediate suspicion.

Warning Signs:

• Consistently positive returns regardless of market conditions
• Returns significantly higher than market averages
• Lack of performance variations
• Claims of guaranteed returns

Market Reality. Successful investing involves accepting market-like volatility. Any adviser promising smooth, unchanging returns is likely misrepresenting their actual performance or engaging in fraudulent activities.

3. Don't Be Fooled by Complicated or Murky Investment Strategies

"If they can't describe the strategy to your satisfaction, walk away. It's a sign they either can't describe it well, don't have time for you, or are up to something more sinister."

Strategy Transparency. A legitimate investment strategy should be clear, understandable, and explicable in simple terms. Complicated, jargon-filled explanations are often used to intimidate and discourage questioning.

Strategic Red Flags:

• Inability to explain investment approach simply
• Heavy use of technical jargon
• Vague descriptions of investment methods
• Claims of "proprietary" strategies that can't be explained

Investor Protection. Demand clarity and simplicity. A competent financial adviser should be able to explain their strategy in terms that a reasonably intelligent person can understand.

4. Ignore Corporate Bling, Exclusivity, and Reputation

"What does money management 'exclusivity' get you? It doesn't lower fees. There's zero evidence it improves long-term performance."

Superficial Distractions. Fancy offices, celebrity connections, and claims of exclusivity are meaningless when it comes to investment performance. These are often tactics used to create an illusion of credibility and distract from underlying issues.

What Doesn't Matter:

• Marble lobbies and expensive decor
• Photos with celebrities
• Charitable contributions
• Political connections
• Claims of exclusivity

Focus on Substance. Evaluate financial advisers based on their actual investment strategies, performance, transparency, and ability to meet your financial goals.

5. Always Conduct Your Own Due Diligence

"No matter who you hire, who you trust, and how many congressional mandates a body has, due diligence is your job—no one else's."

Personal Responsibility. No intermediary, regulatory body, or trusted referral can replace your own careful investigation. Relying on others' recommendations or assumptions is a recipe for potential financial disaster.

Due Diligence Checklist:

• Check SEC registrations
• Review Form ADV
• Verify the adviser's background
• Understand their investment strategy
• Ask detailed questions
• Don't accept recommendations at face value

Proactive Protection. Taking personal responsibility for understanding your investments is the most reliable way to protect yourself from potential fraud.

6. Regulatory Bodies Can't Fully Protect You from Financial Rats

"As much as anyone could or should stop the rats before too many are victimized—theoretically it should be them. Right? But no matter how many process improvements they make, they'll never stop 100 percent of future Ponzi rat scams."

Regulatory Limitations. Government agencies like the SEC have limited resources and cannot comprehensively prevent all financial fraud. They are reactive rather than proactively preventing all potential scams.

Systemic Challenges:

• Understaffed regulatory bodies
• Overwhelming number of financial entities
• Sophisticated fraudsters who can navigate regulations
• Limited investigative capabilities

Personal Vigilance. While regulatory bodies provide a basic framework, ultimate protection depends on individual investor awareness and due diligence.

7. Be Aware of Common Psychological Tactics Used by Fraudsters

"Con artists know precious few investors have spent much time deeply studying capital market intricacies."

Manipulation Techniques. Fraudsters exploit psychological vulnerabilities, using sophisticated tactics to gain trust and discourage questioning.

Common Psychological Tactics:

• Creating an illusion of exclusivity
• Leveraging affinity group connections
• Using technical jargon to intimidate
• Presenting a polished, trustworthy image
• Offering seemingly special opportunities

Investor Defense. Develop a healthy skepticism, ask probing questions, and never be afraid to walk away from an investment opportunity that doesn't feel right.

Last updated: January 9, 2025