There is no real substitute for common sense – except for good luck, which is a substitute for everything.

—Jim Simons

Fraud can happen anywhere at any time because no matter the state of the world, there will always be con artists, hucksters, and charlatans who know how to sell the path to easy riches. And, unfortunately, there will always be people willing to take the other side of that trade. I came across a number of data sources that estimated the amount of money lost to financial fraud each year and the number of people who get scammed out of their money. But the truth is those numbers are always on the low side because there are so many people who get taken advantage of who never report what happened to them because they’re embarrassed. They’re embarrassed because they believed in someone or something that was obviously a scam with the benefit of hindsight, but that they glossed over in the moment.

Because financial fraud is never going away, you must prepare yourself to detect red flags that may arise when listening to an investment pitch. Many warning signs appear clear as day only in hindsight because money often blinds us in the moment from tapping into our common sense. Here are six signs of financial fraud:

1. The Money Manager Has Custody of Your Assets

If you wanted to find a single reason for how Bernie Madoff was able to fool so many people en route to a $65 billion Ponzi scheme, look no further than the fact that he had custody of client assets. This means Madoff’s firm personally held his client’s money, a big no-no. You always want to separate the decision-maker of the investments and the custody of assets. Any reputable money manager or financial advisor should hold the assets of their clients at a third-party bank or outside financial institution. This drastically reduces the risk that a client’s money will get stolen or used as a personal piggy bank of the investment manager.

A multibillion-dollar fund would typically work with a number of financial intermediaries to execute the strategy from an operational perspective. This would include several brokers to execute trades and ensure trading costs were competitive, a fund administrator to calculate and report on the market value of the portfolio, and a bank custodian to actually hold the assets on behalf of the investors. Madoff’s operation performed all of these tasks in house with zero oversight from a third party. They didn’t use an independent custodian which basically gave him free rein to alter client statements, manipulate returns, send out false reports, defy auditors, and do what he pleased with client funds. The reason Bernie is in custody (behind bars) is because he had custody (of assets). And I’ll show myself out.

To do list: Ask your financial advisor or investment manager who has custody of your assets. Make sure it’s an independent third party who allows your investment advisor to trade on your behalf but not transfer funds into and out of your account without your prior authorization.

2. There Is an Aura of Exclusivity in the Pitch

The rich and powerful are different than most people when it comes to managing money because, well, they have more of it. One of the best sales pitches to the wealthy class is making it sound like an exclusive deal because many rich people like to believe they’re special. There are no shortcuts when it comes to investing your money. Good investing is typically boring. But if you’re able to promote exclusivity, that tends to perk people’s ears up a little.

Professional investors like to tout their “proprietary methodology” or “the select group of investors chosen for an exclusive deal” or the “secret wealth-building strategy no one else knows about” or “getting you in on the ground floor.” These types of sales pitches make us feel good because we all want to believe we’re a special snowflake when it comes to managing our life savings. We deserve the secret sauce, right?

Lloyd’s of London is an insurance company in Great Britain that was founded in 1686. The firm has an aura prestige from their long history of working with British aristocrats. In the 1990s, the company touted their reputation as a sound, blue-chip institution to new investors in the United States who were looking for stable returns, and the ability to invest with an exclusive brand. The problem is these new investors were often attracted to the riskiest of insurance products, exposing them to enormous liabilities they couldn’t possibly understand, which meant huge losses for many involved and a lawsuit for Lloyd’s.^[1]

To do list: Ask yourself why the person or firm is sharing an exclusive deal or investment or strategy with you. If it’s so important to keep things a secret, why would they share it with you in the first place? Exclusivity may make a financial scheme feel more important and appealing, but the reality is 99.9% of the time it’s just a sales pitch to get you to hand over your money quicker. Once-in-a-lifetime investment sales pitches tend to come along far more often than once-in-a-lifetime investment strategies that actually work as intended.

3. When the Strategy Is too Complicated to Understand

Will Rogers once said, “I would rather be the man who bought the Brooklyn Bridge than the man who sold it.” Rogers was talking about George C. Parker, the con artist who somehow successfully “sold” the Brooklyn Bridge, along with a few other pieces of property he didn’t own, to unsuspecting buyers. Unfortunately, when it comes to financial fraud, the number of people who are looking to buy the Brooklyn Bridge will always outnumber those looking to sell the Brooklyn Bridge. There will always be a market for these schemes because people are always in search of a shortcut for getting rich.

Making a fraud too complex to understand is one way to get people on board because (a) we all like to believe we’re smart and don’t want to look stupid by admitting we don’t understand something and (b) it’s much easier to be fooled by randomness when something is complicated or hard to understand.

A team of psychology researchers discovered most people who go to see a magician never want to find out how they pull off their magic tricks. Participants in one study were shown a host of magic tricks, including one where the magician made a helicopter disappear. Subjects were then given the opportunity to either get the full explanation about how they pulled it off or watch another magic trick. Surprisingly, 60% of people chose to watch another trick while just 40% asked to see how the illusion was performed.^[2] It’s almost as if people are drawn to mystery. We want to be fooled and there are plenty of people who are more than willing to oblige.

“Trust us, we got this” is the financial pitch of yesteryear, before people had the ability to actually look stuff up on the Internet. This premise rested on the idea that financial professionals know more than you, so just leave them be and let them do what they want with your money. The black box shouldn’t fly anymore in the era of transparency. Professional money managers should be more informed than their clients when it comes to managing wealth, but they should also be able to explain their strategy or philosophy well enough that a 6-year-old could understand it. No legitimate investment strategy should be too murky, flashy, or complicated for clients to understand. The rich and powerful generally avoid the appearance of not understanding something because it makes them look weak. Don’t let your ego get in the way of your financial health.

To do list: If someone either can’t or won’t divulge how they’re managing your money that’s a huge red flag. You can outsource your investments but never outsource your understanding of what’s going on with your money. If it’s too complicated to understand, don’t invest in it.

4. When the Story Is too Good to Be True

General Gregor MacGregor was a Scottish war veteran in South America who pulled off one of the biggest, most diabolical cons of the nineteenth century. Well known for his promotional abilities, MacGregor convinced a large number of his fellow Scots he was the prince of Poyais, a country in Central American. MacGregor described a place with boundless opportunities to plant vegetables, where fruit grew as far as the eye could see, wild game was plentiful for hunting, and rivers were overflowing with gold.

Investors quickly handed over £200,000 in bonds to develop Poyais based on MacGregor’s sales ability alone. Seven shiploads of people boarded boats to sail to a country that was a figment of a con man’s imagination. The boats landed in Honduras, expecting to see a flourishing town, but instead found an uninhabitable landscape. Many of those people became sick or died from the poor living conditions.^[3]

MacGregor used a combination of celebrity from his war exploits and the promise of riches during a time when a decent return on investment was difficult to come by. Somehow he was able to convince thousands of people of the existence of a fictional country thousands of miles away.

In 1908 a scammer posted the following ad in a handful of newspapers:

This is not fake – it does not ask you to speculate, to gamble, nor to canvass. You can do it at home. Five dollars becomes ten – ten dollars becomes twenty dollars. It is absolutely sure, and if you do not prove it true to yourself within a week after we send you our secret we will return your money. The wealthiest men of the country have tried it and succeeded. For two dollars ($2) we will send your secret. Remember, if you find it fails within a week you can have your two dollars back.

Thousands of people sent in their $2 with the hopes of learning how to double their money through this secret. They were sent a reply reading: “Convert your money into bills, and fold them.”^[4] If it sounds too good to be true…you know the rest.

To do list: Stress-test every financial idea or strategy that comes your way by formulating arguments against the idea. Perform a pre-mortem to figure out what could potentially go wrong in advance to help yourself see what you could be missing in the moment. If the returns sound too good to be true, they probably are. If the investment pitch is too good to be true, it probably is. If the promises of riches sound too good to be true, they probably are.

5. When the Returns Are Ridiculously Good

William Franklin Miller worked in a brokerage house in the late 1800s, gaining clients by telling them he had “insider tips.” Through these tips, he marketed an astounding 10% return. But these returns weren’t promised over the course of a year, they were promised over the course of a week. That’s a cool 520% per year! As is often the case with such lofty promises, Miller never actually did anything with the money.

Instead, his main job was spreading the word about his fraudulent investment scheme. He even printed newsletters that read “My ambition is to make the Franklin Syndicate one of the largest and strongest syndicates operating in Wall Street, which will enable us to manipulate stocks, putting them up or down as we desire, and which will make our profits five times more than they are now.” Securities laws were pretty lax back then, but it takes a lot of nerve to blatantly advertise the fact that you’re going to try to manipulate the market. And the worst part is he was never even trying to actually manipulate the market! It was a Ponzi scheme, pure and simple. This scheme began bringing in something like $80,000 a day. Because he was advertising market manipulation right in his marketing materials, it didn’t take long for the authorities to start looking into his scheme. Miller fled to Canada when the scheme was discovered by the authorities and his “investors” were left holding the bag (which was of course empty).^[5]

High promised returns will always suck people in because everyone wants to believe unicorns exist in the financial world. Always remind yourself of the following – if someone could honestly produce consistently enormous returns every week, month, or year, why would they offer you the opportunity to profit with them in the first place? If they truly could earn such fantastic returns, they wouldn’t need to or want to tell anyone else about the secret sauce.

To do list: Be realistic about the level of returns you can earn on any investment you may be pursuing. Do some research to figure out what a reasonable rate of return is and look beyond a sales pitch anytime someone promises you certain return numbers. Anything that’s too high or too consistent is a red flag. Proceed with caution anytime someone makes promises about the future in terms of what your returns will be, especially if they sound too good to be true.

6. When They Tell You Exactly What You Want to Hear

While working hard to discredit medical quack John Brinkley (see Chapter 1), Morris Fishbein of the American Medical Association described three qualities of a charlatan to help others understand how they operate:

1. They wrap themselves inside legends, half-truths, and a grand lie. For Brinkley this meant positioning himself against the medical establishment, selling miracle cures and an alternative to true science.
2. They are extremely selfish. Brinkley never shared his secret medical miracles with any other health professionals, which was a huge red flag because a true doctor would share their results for peer review.
3. They are master manipulators. Charlatans tell people exactly what they want to hear and sell hope to prey on people’s emotions.^[6]

The easiest way to manipulate others is through storytelling ability. The acclaimed book Sapiens: A Brief History of Human Kind by Yuval Harari describes how humans made the leap from relatively tiny groups of simple hunter-gatherers to the more complex modern world full of enormous cities, cultures, groups, and organizations. It wasn’t necessarily a technological breakthrough that did the trick but our ability to tell stories:

How did Homo sapiens manage to cross this critical threshold, eventually founding cities comprising tens of thousands of inhabitants and empires ruling hundreds of millions? The secret was probably the appearance of fiction. Large numbers of strangers can cooperate successfully by believing in common myths.

Telling effective stories is not easy, which is why it’s so difficult for many to spot a fraud even when it’s staring them in the face. These people are wonderful at selling themselves through the power of story. In her book The Confidence Game, Maria Konnikova shares why we so easily ignore facts but take a story at face value, “When a fact is plausible, we still need to test it. When a story is plausible, we often assume it’s true.” She argues that when we hear a good story we almost immediately let our guard down. How else could you explain something like the Nigerian Prince scam? Or the airplane game? Or a doctor that claimed to cure men’s virility by surgically implanting goat testicles into their scrotums? Or a multibillion-dollar Ponzi scheme where no one ever loses money? Stories stick with us while facts and figures do not.

To do list: Every fraud in history has had a wonderful story attached to it. The people hurt by those frauds never bothered to check the legitimacy of those stories. Do your own homework and don’t take anyone’s story at face value simply because you want to believe it. Stories are nice, but verifying the evidence behind any story where money is involved can help save you from yourself.