How to avoid investment schemes in the future

The money that victims of Madoff's alleged fraud may be able to recover by any of a variety of avenues is likely to be limited, and investors need to remember that there is no insurance for investment risk. Here are some lessons that can be learned from this scandal and rules to follow in future investing, according to Kathleen Pender, writing for SFGate.com, Steven Goldberg, writing for Kiplinger.com and James Stewart, writing for WSJ.com:

  • Don't buy what you don't understand. Madoff reportedly told clients he invested in blue-chip stocks and then hedged his positions by trading put and call options on the Standard & Poor's 100 stock index. Madoff said he used something called the "split-strike options" conversions strategy, says Steven Goldberg of Kiplinger.com, who questions how many investment advisers really knew what that was.
  • Know where your money is and who is watching over it. Pender reports that registered investment advisers must place client assets with a qualified custodian, usually a bank or brokerage firm. Advisers can use an independent custodian, an arrangement that provides an extra layer of security, or an affiliated custodian, which apparently is what Madoff did.
  • If your money is with an adviser, find out whether the custodian is independent or affiliated with the adviser and what safeguards are in place to make sure the adviser can't take your money. Do not give him or her permission to withdraw funds, Pender says.
  • Audit the auditor. Make sure your advisor has a reputable accountant. Madoff's only auditor reportedly operated out of a tiny office in suburban New York. A legitimate firm of Madoff's size would have employed at least one well known auditor, Stewart says.
  • Don't rely on middlemen. Many Madoff investors were steered into their investments by advisers, Stewart says. Such middlemen have grown popular because they can manage investments in alternative vehicles like hedge funds. But even though these investments can be more difficult to understand than stocks or bonds, the investor can't abdicate all responsibility.
  • Diversify. Most writers reaffirm this first rule of investing.

Investors are responsible for their decisions, but the question of how Madoff's firm managed to avoid investigation by the Securities and Exchange Commission remains. Congress will be trying to solve this mystery in the coming months, as they review the overall regulatory environment.

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