How to Avoid Becoming a Personal Investing Victim
The Bernie Madoff scandal was a devastating experience for thousands of investors who had placed their trust and money with his firm and lost it all. Madoff's Ponzi scheme also created a crisis of confidence for investment markets and regulators. However, lessons can be learned from the misfortunes of others.
Here are a few red flags that will help you avoid becoming a victim of investment fraud.
Transparency: When working with any financial professional, transparency is vital. The ability to check your investment at any time via any independent source, such as the Internet or a newspaper, can help avoid shady dealings.
In the Madoff scandal, Bernie’s firm kept a tight lid on asset values and investments. Clients would receive a statement once a year with only a dollar value. There was no mention on these statements indicating where the money was invested and, therefore, the clients had no ability to independently verify the value of their investments.
Independence: A way to practically ensure that your money is exactly where you expect it to be is by separating the custodian from the advisor. This means that the institution that is holding your money is independent from the firm or advisor that is managing the money.
Bernie Madoff's investment firm maintained complete control of assets entrusted to them. The statements that clients received were created by his firm and reflected whatever Madoff wanted them to say. There were no checks and balances.
By separating the advice from the custodian, you create a scenario where two entities are sending statements and are accountable to each other. It is extremely difficult, if not impossible, to create a Madoff-type scam if the assets are handled this way.
Returns that are too good to be true: Even the best financial advisors and money managers experience difficult times. The path to profitable returns is rarely a straight line. Although advisors or the market could produce a series of large returns, an investment professional with a 20-year streak of well-above-average returns each year raises a red flag.
Many talented financial professionals have a long-term history of performing better than average. However, even the best money managers go through slumps. Warren Buffet has had numerous years when his performance fell short of the market. However, it is his overall return that makes him so talented, not a perfect record.
Use common sense: We should all be a little wiser after the experiences in the market, economy, and scandals of the past several years. Let common sense be your guide. If the way your money is being handled doesn’t sit well with you, don’t be afraid to investigate or make changes.
Giving one person the keys to your kingdom may seem easy, but it can lead to problems later. Using your head and focusing on independence will be very difficult for someone to take advantage of you and your money.
Investing GlossaryAn individual with net worth of more than $1 million (alone or jointly with a spouse) or with income of $200,000 in each of the past two years and with a reasonable expectation of the same level of income in the current year. Certain higher-risk investments are often restricted to accredited investors.
Investing GlossaryA risk-adjusted measure of performance. Alpha measures the portion of an investment’s return attributable to the security’s inherent values (for example, earnings growth) rather than to overall market movements.
Investing GlossaryA trading technique that takes advantage of price discrepancies when the same security, currency, or commodity is traded on different markets.
Investing GlossaryA condition that is met when an option’s strike price is the same as the prevailing price for the underlying stock. For example, if stock ABC is trading at $125 and the option’s strike price is also $125, then the option is at the money.
Investing GlossaryA financial statement that shows the value of a company’s assets, liabilities, and owner’s equity on a given date. Total assets minus total liabilities equals owner’s equity.
Investing GlossaryA situation that occurs when you have sold something you do not own. In commodities, if you enter into a contract to sell a commodity which you don’t own with a promise to deliver it at a set price on a future date, then you are short that commodity. In stocks, you are short a stock if you have sold it and borrowed the shares from a broker to deliver to the purchaser, with an obligation to replace the borrowed shares at a future date. Being short means that you’re bearish, or negative on the market, and that your goal is to make money when the security or commodity that you choose to short falls in price.
Investing GlossaryA measure of a stock’s relative volatility. A stock with a higher beta can be expected to rise or fall more than the overall market, whereas a stock with a lower beta is less volatile than the overall market.
Investing GlossaryA theoretical model used to calculate the fair market value of an option based on time to expiration, price of the underlying stock, historical volatility, strike price, and carrying costs.
Investing GlossaryA contract that gives the holder the right to buy a particular asset at a specified price at any time prior to the expiration of the option.
Investing GlossaryA bond that the issuer can redeem before its maturity date. The bondholder is often paid a premium when the bond is called.
Investing GlossaryA chart that shows the daily high, low, opening, and closing prices for a security over a specified time period.
Investing GlossaryThe profit from the sale of an investment at a price that’s higher than the purchase price.
Investing GlossaryAn interest-bearing investment issued by a bank. CDs are typically available with maturities ranging from three months to five years.
Investing GlossaryBuying and selling securities by a broker for the sole purpose of generating commissions.
Investing GlossaryA call option written by an investor who already owns the underlying shares. If you write a covered call and the option is exercised by the holder, then you would just deliver the stock to the holder.
Investing GlossaryDelta represents the price change of an option for every one-point change in the price of the underlying security or futures contract.
Investing GlossaryA financial instrument whose value is based on the value of another asset or index. A stock option, for example, is a type of derivative that gives you the right, but not the obligation, to buy shares of the stock at a predetermined price. The option’s value changes in relation to the price of the stock.
Investing GlossaryAn electronic order-routing system used by NYSE member firms to send market and limit orders directly to the specialist at the exchange who trades that particular security.
Investing GlossaryMoney paid out by a company to the owner of its stock. An income stock is a stock that has a regularly paid, higher-than-average dividend.
Investing GlossaryA market in which stock shares are issued and traded. Trading takes place through both exchanges and over-the-counter markets.
Investing GlossaryA mutual fund that is traded, like stocks, on an exchange.
Investing GlossaryCurrency that a government declares to be legal tender, even though it is not backed by reserves of physical assets (such as gold). The value of fiat money derives solely from the public’s confidence and faith in its ability to serve as a storage medium for purchasing power. Most of the world’s money is fiat money.
Investing GlossaryThe largest non-governmental regulatory organization responsible for overseeing all securities firms that do business in the United States. Responsibilities include professional training, testing and licensing of registered representatives, and arbitration and mediation.
Investing GlossarySpeculation on the value of one currency versus another, in which you buy one country’s currency—just as you’d buy a stock or other security—in the hope that it will appreciate relative to the value of another currency.
Investing GlossaryContracts where you agree to buy or sell a specific amount of a commodity, currency, or other asset at a specified price on a specified future date. Unlike an option, a futures contract creates an obligation, rather than just a right, to buy and sell the underlying security.
Investing GlossaryWhen you own a security or other asset, you are said to be long that security. When you go long (that is, buy) a security, you’re bullish, or positive on the market, and you expect the price of that security to go up.
Investing GlossaryPrivately held corporations created by Congress to work for the common good—generally to facilitate borrowing for homeowners, farmers, and other specific groups. Examples of GSEs include Fannie Mae, Freddie Mac, and the Federal Farm Credit Bank.
Investing GlossaryA chart formation in a graph of an asset price that resembles three mountaintops in a row, with the middle mountaintop being taller than the other two. The pattern indicates a trend reversal, meaning that prices are expected to fall.
Investing GlossaryAn investment strategy that allows you to reduce the risk of an unfavorable price change in a security or commodity. For example, a stockholder of ABC Company who is worried about declining stock prices can offset that risk by buying a put option on ABC, allowing him to sell his shares in the future at today’s price.
Investing GlossaryInvestments that don’t trade very actively and are difficult to sell on short notice.
Investing GlossaryA theoretical value representing the volatility of the security underlying an option. Implied volatility is used by the Black-Scholes model, among others, to calculate the price of an option. Implied volatility usually rises when the markets are in downtrends, and falls when the markets are in uptrends.
Investing GlossaryA condition that is met when a call option’s strike price is below the prevailing price for the underlying stock. For example, if stock ABC is trading at $125 and the option’s strike price is $120, then the option is in the money. For a put option, the strike price must be above the current market price of the stock for the option to be in the money.
Investing GlossaryA mutual fund designed to mirror the performance of a specific market index such as the Dow Jones Industrial Average or the S&P 500. Expenses of index funds tend to be lower than other mutual funds because the manager is not actively researching, buying, and selling securities.
Investing GlossaryA type of individual retirement savings plan. There are several types of IRAs, including, among others, Traditional IRAs and Roth IRAs. Traditional IRAs are tax-deferred accounts that currently allow individuals to contribute up to $5,000 per year. Contributions to a Traditional IRA may be tax deductible, depending upon several factors. You don’t pay taxes on the income and gains you generate in a Traditional IRA until you make withdrawals; all withdrawals will be taxed at the ordinary income tax rate. Roth IRAs are subject to different tax treatment.
Investing GlossaryThe degree to which an investor or business is utilizing borrowed money. For investors, leverage is a means of multiplying the return on an investment by borrowing money to purchase additional securities or other assets. Buying securities on margin is an example. If you have $1,000 of cash and borrow another $1,000 from your brokerage, you could then purchase $2,000 of stock. If the value of the purchased stock increases by 10 percent ($200), then you have realized a 20 percent gain ($200/$1,000) on your actual cash investment.
Investing GlossaryThe value of a company as measured by the total number of stock shares outstanding times the market price of each share. For example, if company ABC has 20 million shares outstanding, and each share is currently worth $100, then the market cap for ABC is $2 billion. In general, stocks are classified as large cap (over $5 billion), small cap (under $1 billion), or mid cap (anything in between).
Investing GlossaryA stock index where the effect of each stock on the index is in proportion to its market value.
Investing GlossaryA major ongoing development that is expected to have significant implications for most (if not all) facets of society over an extended period of time. The aging of the American population is an example.
Investing GlossaryThe perceived strength behind a price or volume movement in a security based on the rate of acceleration of that movement.
Investing GlossaryIn technical analysis, a chart line that shows the average of a security’s price over a specified period of time, recalculated for each new data point. For example, a 30-day moving average will include yesterday’s price and those for the previous 29 days. Tomorrow’s moving average will include today’s price but will drop the price for the earliest date in yesterday’s average. The moving average is used to spot pricing trends by flattening out large fluctuations.
Investing GlossaryA bond issued by a local or state government or agency. Munis generally raise money for public projects such as hospitals, roads, bridges, and sewer systems as well as general governmental operations. When you buy a muni, the interest is usually exempt from federal income tax.
Investing GlossaryA fund operated by an investment company that raises money from shareholders and invests that money in a group of assets in accordance with one or more stated objectives, such as income, growth, aggressive growth, and so on. A mutual fund may generally invest in stocks, bonds, options, futures, currencies, and money market securities in accordance with its stated parameters. All shareholders share equally in the income, gains, and losses generated by the fund.
Investing GlossaryA call option written by an investor who does not already own the underlying shares. If you write a naked call and the option is exercised by the holder, then you would have to buy the stock at the market price to meet your obligation. Naked calls are very risky, though potentially very rewarding.
Investing GlossaryAn electronic stock exchange established by the National Association of Securities Dealers (NASD). The Nasdaq lists over 3,200 companies and is the largest equity securities trading market in the U.S.
Investing GlossaryA system where traders on a trading floor or in a trading pit shout and use hand signals to make transactions or trades with each other.
Investing GlossaryA derivative security that gives the holder a contractual right to buy or sell a set amount of a stock, commodity, or other asset at a specified price on or before the option’s expiration date. An option is purchased for a fee, called a premium.
Investing GlossaryA person who is buying options. Call option holders have the right to buy a stipulated quantity of the underlying asset specified in the contract at a specified strike price. Put option holders have the right to sell the specified amount at the strike price.
Investing GlossaryA condition that is met when a call option’s strike price is above the prevailing price for the underlying stock. For example, if stock ABC is trading at $120 and the option’s strike price is $125, then the option is out of the money. For a put option, if the strike price is below the current market price of the stock, then the option is out of the money.
Investing GlossaryA securities market where trades are conducted by phone or computer network directly between dealers rather than on a physical trading floor. All bonds trade over-the-counter, as do unlisted stocks (generally, stocks of smaller companies that do not qualify for listing on an exchange).
Investing GlossaryWhen you buy an option, the premium is the amount that you pay to the seller of the option.
Investing GlossaryA contract that gives the holder the right to sell a particular asset at a specified price at any time prior to the expiration of the option.
Investing GlossaryA company, usually traded publicly, that raises money from shareholders and invests that money in a portfolio of real estate properties. REITs are modeled after mutual funds, although the tax treatment of REIT income is different.
Investing GlossaryA statistical technique used to find the mathematical relationship between a dependent variable (such as a company’s stock price) and one or more independent variables (such as GDP, income growth, or inflation). Regression analysis is used to predict future values of the dependent variable based on changes in the independent variables.
Investing GlossaryA price movement in the opposite direction of the previous trend. When a price has gone too far and traders deem the security overbought or oversold, the price may stop rising or falling and move in the opposite direction for a period of time.
Investing GlossaryA type of IRA in which contributions to the account are not tax-deductible, but qualified withdrawals are completely exempt from federal income tax.
Investing GlossaryA federal agency whose mission is to protect investors from fraud or other unlawful market activities.
Investing GlossaryA nonprofit corporation created by Congress in 1970 to protect investors in the United States. SIPC insures the assets in investor accounts (up to certain maximum amounts) at registered brokerage firms in the event of bankruptcy of those firms.
Investing GlossaryAn instruction to a broker to sell a stock at the market price after the security has touched the specified stop price. A sell stop is always placed below the present market price and is usually designed to protect a profit or limit a loss.
Investing GlossaryThe general feeling among investors as to which direction the stock market is heading. If the sentiment is that prices are going up, it is said to be bullish; if the sentiment is toward a downward movement, it is bearish. Investors base sentiment on market activity and movements in the prices of securities.
Investing GlossaryA situation that occurs when you have sold something you do not own. In commodities, if you enter into a contract to sell a commodity which you don’t own with a promise to deliver it at a set price on a future date, then you are short that commodity. In stocks, you are short a stock if you have sold it and borrowed the shares from a broker to deliver to the purchaser, with an obligation to replace the borrowed shares at a future date. Being short means that you’re bearish, or negative on the market, and that your goal is to make money when the price of the security or commodity that you choose to short falls in price.
Investing GlossaryA retirement plan available to small employers and self-employed individuals in which both the employer and employee can contribute to an IRA.
Investing GlossaryAn annuity contract that you purchase from an insurance company with a single upfront payment. An SPIA usually starts making regular monthly payments to you immediately.
Investing GlossaryYou create a straddle when you simultaneously buy a put and a call on the same stock at the same strike price and with the same expiration date.
Investing GlossaryYou build a strangle when you buy a put and a call on the same stock with the same expiration date but at strike prices that are equally out of the money. A strangle costs less than a straddle because both options are out of the money, but you only make a profit if the price of the underlying stock moves dramatically.
Investing GlossaryThe price at which the stock or commodity underlying an option can be purchased (call option) or sold (put option) pursuant to the terms of the contract.
Investing GlossaryAn exchange of streams of payments over time according to specified terms. The most common type is an interest rate swap, in which one party agrees to pay a fixed interest rate on a notional principal amount in return for receiving an adjustable rate from another party.
Investing GlossaryOne-sixteenth of a point.
Investing GlossaryA price change in a security’s trades. If the next trade takes a security up in price, it’s an uptick; if it takes the security down, it’s a downtick. In futures and options trading, a tick is the minimum change in price, up or down.
Investing GlossaryThe spread between the high and low prices of a security or commodity within a particular period.
Investing GlossaryDebt obligations of the U.S. government that are secured by its full faith and credit. Treasuries include bills (maturities of less than one year), notes (maturities of 1 to 10 years), and bonds (maturities of more than 10 years).
Investing GlossaryA statistical measure of the movement of a financial asset's price over time, gauging how fast the price of the asset changes. The price of a highly volatile security can change dramatically over a short period of time. A measure of the volatility of a security relative to the overall market is its beta.
Investing GlossaryA person who is selling options. Call option writers have the obligation to sell a stipulated quantity of the underlying asset specified in the contract at the specified strike price if the option is exercised by the holder. Put option writers have the obligation to buy the specified amount at the strike price if the option is exercised.
