If you want to avoid falling prey to the Ponzi scheme of someone like Bernie Madoff, the first and most surprising rule you should adopt: Don't trust referrals from your neighbors or friends.
At least, don't rely on the referral to make your decision. Though many advisors have their clients' best interests at heart, there are fraudsters who take advantage of the ready access to their clients' money.
Their chief tool: what the experts call affinity fraud—preying on our tendency to trust referrals from people in our social circles, ethnic or religious groups.
Many of these folks suck in their victims by telling them what they want to hear, when it comes to delivering a return on their investment, according to Tony Fiorillo, a fee-only advisor who is president of Asset Management Strategies in Fishers, Ind., and works closely with a law firm that has sued stockbrokers for allegedly victimizing clients. It usually takes a while for the investors to discover that the fraudster can't deliver. Meanwhile, the predators take advantage of word-of-mouth referrals to move from one victim to the next.
"This is a very, very sleazy business in a very expensive suit," Fiorillo said.
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Affinity fraud is one of the most common ways to victimize investors, according to the FBI. A recent global survey by Nielsen of 28,000 people found 92 percent believed word-of-mouth referrals and recommendations from friends and family more than any other form of advertising.
Madoff found his victims among members of Palm Beach Country Club and in Jewish organizations where he was trusted. Fraudsters have preyed upon many other groups. Marcus Schrenker—the Indiana financial advisor who tried to fake his own death in a staged 2009 plane crash in Florida and was later convicted of securities fraud—reportedly got enthusiastic word-of-mouth referrals from retired airline pilots. Roy Fluker Jr., who was sentenced in Chicago to 15 years in prison in 2011 after defrauding 2,000 people of $10.7 million, preyed upon African-American church congregants, according to the FBI.
Some cases don't rise to the criminal level and are settled in civil court. In 2012, there were 4,299 arbitration claims filed with FINRA against investment advisors for allegedly breaching their fiduciary duty, misrepresenting information, omitting facts and other infractions, compared with 4,729 in 2011.
No matter how trustworthy someone seems—or how much faith you have in the person recommending him—don't go by first impressions, experts warn.
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