How to Avoid the Next Madoff (especially if you work with a financial advisor)

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Over five years ago, Bernard Madoff was sentenced to 150 years in prison for scamming many investors–both novice and expert–out of billions of dollars.  It surprised me that so many experienced investors could fall for his lies and believe that his consistent returns were legit.  Many of Madoff’s victims were clients of financial advisors, who had foolishly invested their clients’ funds with Madoff.  I think we should expect financial advisors to be able to avoid a scam, but apparently they are just as likely as regular investors are.  In a recent Forbes magazine article called “Three Ways to Ward Off the Next Madoff,” Hardeep Walia offered three suggestions for avoiding “being seduced by another Madoff.”  I’d encourage  you to read his article as he gave some good suggestions, but I’d like to offer my own spin by giving you three tips for avoiding the next financial advisor who might invest with Madoff!
1) Only work with a Fee-Only Advisor: this type of advisor is not “in bed” with the investment products that he/she recommends to clients.  In other words, the advisor’s fee comes directly from you, the client, and so his/her loyalty is not split between you and the investment firm.  In the case of Madoff, he most likely was paying advisors to recommend his funds, and this would not not happen if you work with a fee-only advisor.
2) Only work with a financial advisor who recommends passive mutual funds from respected firms like Vanguard and Dimensional Fund Advisors. Passive funds are very easy to understand, since they usually own all of the stocks or bonds in a specific asset class. If you avoid advisors who use actively managed funds, like Madoff’s, to try to beat the market, then you will never have to worry about being scammed.  All investment scams involve selling the hype of earning a much higher investment return than the market (or what’s normal), or maybe earning a high investment return even when the markets are down.  Research from top business schools (like Chicago) show that most investors cannot beat the markets over long periods of time and that the ones who do are simply lucky.  Investment returns are usually volatile and do not occur consistently over time, so Madoff’s sales pitch was bogus and a good investment professional should have seen through the smoke.  If you are working with an advisor who believes he/she can “beat the market,” you are taking a lot more risk than you need to, so find a new advisor!
3) Only work with low cost advisors that use low cost mutual funds.  As Hardeep said, “high fees create a performance hurdle that encourages risk-taking,” so you want to avoid expensive advisors or those who recommend expensive investments.  In my opinion, advisors who charges more than 1.5% annually (on your investments) or who recommend funds that cost more than 50 basis points (.5%) are on the expensive side.  For many commission or fee-based advisors, you may be paying a lot more than what they tell you because some of their fees are not fully disclosed.  It never hurts to get a second opinion if you aren’t sure.
My final thought on avoiding scams and advisors who “unknowingly” recommend them is to get more involved in your personal finances and learn as much as you can.  The best advisors are as selective about their clients as you should be about picking your advisor.  One of the key criteria that I use for accepting new clients is how willing they are to learn some basic financial concepts so they have realistic expectations.  If you have the right expectations, you won’t be fooled by a scam artist or hire an advisor that uses someone like Madoff to manage your investments.