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You can’t rely on the government to protect you against fraud, but you can protect yourself.

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Guard Your Money From the Next Madoff

You can’t rely on the government to protect you against fraud, but you can protect yourself.

Is there no end to scandal…fraud…and collapse in 2008?

Is your money really safe?

It’s getting harder and harder to hold on to your hard-earned assets. Threats are everywhere — from your broker who gives you bad advice in a treacherous bear market, from the Federal Reserve which is quickly destroying the value of the dollar through easy credit and inflation, to Congress, who will be forced to raise taxes to pay for the ever-expanding bailouts and deficits.

And now your pocketbook is threatened by outright fraud.

There are two lessons from the $50 billion collapse of Wall Street veteran Bernie Madoff’s managed accounts.

First, you can’t count on the federal government, especially the Securities & Exchange Commission (SEC), to protect your hard-earned money. The feds are like the police, who are better at finding criminals than preventing crime.

In fact, there is a fundamental reason why the SEC misses most fraud cases: The SEC is often in bed with the investment houses. George Stigler, professor of economics at University of Chicago and long-time colleague of Milton Friedman, demonstrated many years ago that over time regulatory agencies are captured by the companies they regulate. Not surprisingly, many ex-SEC employees are hired by broker/dealers to keep the SEC at bay. That’s apparently what happened at Madoff Investment Securities. A team of SEC lawyers investigated Madoff’s broker/dealership a few years ago and found nothing amiss.

Second, the Madoff case is so large and hurtful to so many investors, from Steven Speilberg to small Jewish foundations, that the Democratically-controlled Congress will have another big reason to impose another heavy dose of regulation on Wall Street. Sarbanes-Oxley will look like a band aid compared to what’s coming down Pennsylvania Avenue.

Of course, looking back, investors have only themselves to blame if they got caught losing their shirt. Sure, Bernie Madoff had impeccable credentials on Wall Street. If you can’t trust the former chairman (founder) of Nasdaq, who can you trust? But there were plenty of red flags:

1. Refusal of promoters to reveal exactly how Madoff made money: Clients were always told that his option strategy on index funds was “it’s too complex” to explain. Smart investors will avoid managed accounts they don’t understand.

2. Accounts made money too consistently. Madoff’s managed accounts showed steady returns of 8-12% year in and year out no matter what, whether the markets were rising or falling.

3. Madoff’s managed accounts had no separate custodian and no independent outside auditor.

4. High-profile lifestyle: Bernie Madoff was living high off the hog with a $9 million two-floor apartment in Manhattan’s Upper East Side as well as an elaborate beachfront home on Long Island. Fraud promoters almost always live high-profile lives.

How to avoid financial fraud? I always urge my subscribers to manage their own funds as much as possible with large, reputable discount brokers (like Charles Schwab) where the federal insurance guarantees accounts. If investors are still tempted to turn their money over to managed accounts, I urge them to make sure they diversify into several managed accounts, so that no one account is so large that it leaves them penniless. Managed accounts should also include publicly-traded no-load mutual funds, whose value can be tracked daily. And most importantly, investors should make sure all managed accounts have separate custodians and independent outside accountants to audit their accounts.

I wonder what shoe will drop next. Again, I urge readers to be cautiously conservative in today’s market. Be well diversified in quality blue-chip stocks and funds, maintain a high level of cash, and buy gold.

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