Our Insights

About personal finance, investments and markets.
February 7, 2017

How to avoid fraud

Avoiding permanent loss of capital is key for any investor. One of the biggest risks is fraud. While there are many official checklists (see below) we want to present here our common-sense tips that have helped us circumvent investment fraud. If you have questions about any specific investment, don’t hesitate to contact us.

1. Only invest in publicly traded funds with an ISIN

What do most frauds have in common? They are all-too-often private investment placements targeted solely at individual investors. Unlike mutual funds or ETF, those investments get little scrutiny from regulators and their current value is not transparent because they do not trade on an exchange (hence they have no security identifier = ISIN).

Non-traded investment products that are only targeted at retail investors are to be avoided. Institutional investors employ a large number of professional analysts that are well trained at spotting potential flaws or even fraud. If a fund promoter is looking to avoid institutional investors it should set your alarm bells ringing.

But why do “advisors” pitch non-traded private funds (in Germany they are mostly called „Geschlossene Fonds“)? Because the pay high commissions. The conflict of interest is obvious.

2. Beware of high fees

Scam artists are in it to make money. Getting rich quick is their main business model and the easiest way to achieve this is with high fees. Unsurprisingly, all the recent well known frauds such as Madoff in the US or S&K in Germany had a high fee structure.

But where should investors draw a line? We set very strict limits:

  • No performance fees
  • No upfront fees (sometimes called „sales commission“)
  • Max 1.0% annual management fee

With this harsh set of rules you would automatically weed out 99% of all investment products on the market. Now we are not saying that virtually all products are frauds, but with this simple screen you would have avoided all the major frauds – what more could you ask for?

3. Unrealistic returns

If it sounds to good to be true, it probably is. Compare promised yields with long-term equity market returns. Any investment opportunity that claims you will get substantially more could be highly risky.

Let’s put some real numbers behind this. Over the last 100 years, equities returned approx. 5% more than 10 year government bonds. This is called the equity premium and it makes intuitive sense because as an investor you want to be compensated for holding a more volatile asset class. At the moment, a basket of global government bonds yields only 1%-2%. If you start with 1%-2% bond yield and then add a 5% equity risk premium on top you get total expected equity returns in the ballpark of 6%-7%. As a rule of thumb, any investment that targets a return higher than 7% today should be regarded with a healthy dose of skepticism.

A warning example

People don’t like to admit it, but they don’t know everything. Often when they are successful in one field they believe they also know best in other areas. One of my favorite examples is Stephen Greenspan, a psychologist whose research focuses on gullibility and human fallibility. In December 2008 he published a book called “Annals of Gullibility: Why We Get Duped and How to Avoid it“. The same month Bernie Madoff’s $65bn Ponzi scheme unraveled. Here is the “fun” part: Greenspan himself was a Madoff investor! The person who wrote a book on gullibility was duped in the largest Ponzi scheme of all time…

This is why ego can be so self-destructive. We are often our own worst enemies and when it comes to investing, it makes sense to remind ourselves how much we don’t know.