Types of Investment Risk: Fraud/"Madoff"

Published on June 12, 2013

We are in the middle of a series breaking down the various types of investment risks. You can read the introduction here. We are posting one article covering one risk each weekday until the series is complete.

Yesterday we covered Illiquidity, and today we are covering...

Risk #3: Fraud/"Madoff" Risk

Description: After massive scandals such as Worldcom and Bernie Madoff's hedge fund Ponzi scheme, fraud risk has been at the forefront of many investors' minds when considering investments. Fraud risk may mean that you are not actually investing in what you think you are or that the performance of the underlying investment is actually worse than represented. You may be swindled out of some or all of your money depending on the scale of the fraud or deception.

Primarily Applies to... All investments are potentially subject to this risk.

Real World Examples: The original Ponzi scheme. Bernie Madoff ran a 50+ Billion dollar Ponzi scheme. Worldcom deceived just about everyone through their fraudulent accounting practices. That Nigerian prince who keeps emailing you.

Extreme Avoidance Measure: Put your cash under your mattress.

Potential Mitigations: While the strictest due diligence cannot guarantee complete protection from fraud, it can certainly weed out a lot of the crooked operations out there that are looking for lower hanging fruit. The best potential mitigation to fraud risk is diversification. Having all of your eggs in one basket significantly increases the risk that an act of fraud could be devastating to your overall portfolio. If, on the other hand, you have spread your risk over many separate operators and investments, the impact of fraud in any one investment has less of an effect on the overall portfolio.

Stay tuned, tomorrow's highlighted risk is: Market/Socionomic.