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What do you do when you hear the term “financial adviser”? This term is nebulous and includes everything to insurance agents, tax prepares, from the fiduciary fee-only advisers. Most financial advisers are honest, competent professionals, while others are dishonest and have severe interest conflicts. However, you must know common scams and conflicts of interest some financial professionals could potentially have, including Ponzi Schemes, Misrepresentation Fraud, Affinity Fraud, pushing high fee products, and churning.
The first Ponzi Scheme was committed by its namesake, Charles Ponzi, in the early 20th century. Per the Securities and Exchange Commission (SEC), “A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Advisers that conduct these schemes convince new investors to work with them by promising opportunities that supposedly generate returns with little risk. Then, the investment earnings are just the new investors’ original capital distributed to existing clients. Typically, advisers who start Ponzi schemes take money from the original investments to live an exorbitant lifestyle.
This scheme is a classic and includes parts of other fraudulent activities, such as promising high returns. The best way to protect yourself against a Ponzi scheme is to avoid opportunities that seem too good to be true. For example, the average annual stock market return is 7-8% over the long term. Thus, it would help if you were wary of any adviser that can claim much higher returns than 7-8% with little risk. These returns aren’t consistent, and safer investments produce smaller returns than riskier ones.
Affinity Fraud is typically used with Ponzi schemes and preys on a specific racial or ethnic group. This method is very effective because we generally trust members of our similar background. Since there is an initial trust factor, it makes it easy to sign up new participants. An extreme version of affinity fraud is when the fraudster would pretend to be part of a specific race or ethnic group.
Bernie Madoff, a disgraced investment adviser who created the largest Ponzi scheme in history, is a great example of affinity fraud. Mr. Madoff used his Jewish roots to create connections with wealthy Jewish financiers and philanthropists. He would go to Jewish gatherings and country clubs to sign up victims in what became a 64.8 Billion scam. Luckily, Mr. Madoff was arrested for securities fraud and other charges in 2009 and is currently serving a 150-year prison sentence.
Financial advisers can misrepresent their credentials to unsuspecting clients. Since there is no one credential or licensing requirement to practice, misrepresentation is a relatively easy scam. There are more than a dozen financing planning designations, which include certified financial planner (CFP), registered investment advisor (RIA), certified public accountant (CPA), chartered financial analyst (CFA), among others. Most people aren’t aware of these designations and the specific requirements to achieve and maintain each one. Thus, a potential customer could be receiving guidance from an unqualified individual.
Since “financial adviser” is a broad term, the compensation methods greatly vary. For example, some professionals are compensated through commissions when you buy and sell investments, others charge a percentage of your portfolio (typically 1%), and some charge per hour. One of the biggest conflicts of interest is pushing investments with high loads and fees. A load is a percentage of the selling price charged to the buyer. So, if you buy shares of a mutual fund worth $10,000 that comes with a front-end load of 5%, you lose $500 of your initial investment from the start.
Another type of load is a back-end load, meaning that you will be charged a certain percentage of the sales price if you decide to sell. For example, some investment products have a back-end load of 4% in the first year, which decreases 1% for each year you hold on to it. Luckily, most back end loads disappear over the long term, but these fees negatively impact short term liquidity.
Lastly, it’s important to be aware of a mutual fund or ETF expense ratio. Some funds can have expense ratios as high as 3%, with the average around 1%. While a percent might seem insignificant, it can cost you hundreds of thousands of dollars in the long run. The below chart will show you a comparison of similar performing funds with different expense ratios. The lower expense ratios saved the investor thousands of dollars over decades. Luckily, anyone can start investing, and there are plenty of low-cost funds available.
Financial advisers can vary, with the majority being ethical and knowledgeable professionals. However, some financial professionals are dishonest and incompetent. Before you work with one, you should how the adviser is compensated along with common investment scams and conflicts of interest. These conflicts of interest and scams include Ponzi Schemes, Misrepresentation Fraud, Affinity Fraud, selling high fee products, and churning. What other financial scams should you know before working with an adviser? Please tell us below!