How to Smell a Rat: The Five Signs of Financial Fraud

Imagine your life savings as a precious treasure, carefully accumulated through years of hard work and sacrifice. Now imagine entrusting that treasure to someone who not only decides how to invest it but also holds the keys to the vault where it is kept. This is the essence of the first and most critical warning sign of financial fraud: when your adviser also has custody of your assets. Never hire any form of money manager or adviser who takes custody of your assets. This simple rule is your strongest defense against the devastating losses caused by financial swindlers.

History offers chilling lessons. Consider the infamous case of a man who managed billions for decades, trusted by hedge funds, charities, and even Hollywood stars. His scheme unraveled only when the bear market’s pressure revealed the cracks. This was no coincidence. Fraudsters rely on direct access to client funds to manipulate and misappropriate money at will. When custody and decision-making are combined, the temptation and opportunity to embezzle become overwhelming.

Separating these roles is akin to building a secure fence around your treasure. You decide where to place your wealth, but a separate, reputable custodian holds the keys. This custodian is often a large, well-known bank or brokerage firm, equipped with robust legal and technological safeguards. For example, during the collapse of a major financial institution in 2008, clients whose assets were held by independent custodians retained ownership of their securities. Their investments did not vanish with the bank; they simply moved to safer hands. Having your assets held at a big-name custodian provides a nuclear-proof firewall that keeps your money safe.

Beware of advisers who promise convenience by combining custody with investment decisions. It may seem easier to write a check directly to them, but this convenience is a trap. The risk of theft is real and proven. Even when advisers start with honest intentions, the lure of easy access can lead to temptation and eventual betrayal.

To protect yourself, insist on an account in your name at a third-party custodian. Make sure this custodian is independent and large enough that your adviser cannot collude with them. Your adviser can have limited authority to buy and sell investments on your behalf, but never the ability to withdraw funds without your explicit permission. This structure ensures your money is safe even if the adviser turns rogue.

Remember, the best fences make the best neighbors. By building this fence around your assets, you create a boundary that fraudsters cannot cross. This foundational step sets the stage for understanding other warning signs of financial fraud. As we move forward, we will explore how too-good-to-be-true returns and murky strategies can further reveal the rats hiding in the shadows.