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Protecting Yourself Against Advisor Risk

Published in Articles on March 19, 2019

In recent years, you may have seen headlines in the news about professionals in our local community who have violated their client’s trust through illegal and reckless practices. While holding themselves out as trusted professionals, they have engaged in practices ranging from Ponzi schemes to collecting unauthorized fees and promoting inappropriate investments. Fortunately, there are steps you can take as an investor to significantly reduce your exposure to these risks and other deceptive practices.

Ponzi Schemes

The allure of high returns often blinds investors to the risks of their investment options. Ponzi schemes are driven by taking advantage of our instinct to chase after high returns. They purport some form of income strategy with the promise of above-average returns with little or no risk. The promoter will pay high returns to attract investors and entice existing investors to invest more money. Many Ponzi schemes begin as legitimate investment vehicles, such as hedge funds or other pooled investments. However, pooled investments can quickly degenerate into a Ponzi scheme after the income strategy unexpectedly loses money.

When are you at risk of investing in a Ponzi scheme? Any time you invest directly with an individual or entity that takes custody of your money. You can eliminate the possibility of investing in a Ponzi scheme by following one simple rule: Always use a reputable third-party custodian (i.e., Schwab, TD Ameritrade, Fidelity, Vanguard, etc.). An independent third-party custodian holds your investments and provides you with on-line access and monthly statements. You should use your third-party custodian to verify your investment performance. Your investment advisor should have only limited access to your account, including ability to execute trades and facilitate authorized money movement. Your investments should be held in your own investment account and not in your advisor’s account.

Unauthorized Fees and Commissions

Establishing trusted relationships is critical as you seek out competent investment advice. Once you have established a relationship with an advisor using an independent third-party custodian, it is easy to find yourself on autopilot with professionals you trust. However, you must not become complacent in that relationship. You still need to verify that they are complying with the terms of your agreement. It is important to understand how the investment professional is receiving compensation and the amount of compensation they are entitled to collect.

Advisors adhering to the fiduciary standard of care should disclose all conflicts of interest, including compensation. You should understand how your advisor’s compensation is calculated and verify that you are charged the correct fee or commission amounts. If your advisor does not disclose fees or commissions, you should not continue the relationship. You should be able to trace these payments back to your investment account at the independent third-party custodian. In some cases, you may consider seeking out a second opinion to help ensure unauthorized fees and commissions have not been taken from your investment account. You may trust your investment advisor, but always verify that the fees and commissions you are paying are correct.  

Inappropriate Investments

After you open an account with an independent third-party custodian and verify that the investment fees and commissions are reasonable and accurate, make sure you understand the investment products and strategies you are using. Avoid entering into complex investment contracts. Many investment contracts prevent you from liquidating your investment. Others will charge large penalties and surrender fees to liquidate. Some contracts use leverage, which may expose you to inappropriate levels of risk. Futures and options are examples of investment contracts that may subject you to unlimited losses.

Often, the professionals promoting complex investment contracts do not fully understand the details of the agreement and the risks involved. If they can’t clearly and adequately explain the details of the investment product or strategy and you don’t understand the investment, then don’t invest. If you don’t take the time to understand your investments, then you are exposing yourself to undue risks. You may end up trusting an investment professional that either knowingly or unknowingly is engaging in reckless investment practices.

Don’t become a victim of the unscrupulous actions of others. You can avoid the risk of these and other devastating losses by remembering these basic investment rules:

  • Always use an independent third-party custodian,
  • Always verify that your fees and commissions are correct, and
  • Always avoid complex investment contracts that you do not understand.

If an investment seems too good to be true, it most likely is. It is always a good idea to obtain a second opinion as you evaluate your investment options. Your CPA can provide you with an independent voice as you search for objective investment advice.