How to Spot an Investment Con (So You Don't Fall for the Next Madoff)

Big nosed lying salesman

He may be festering in prison for the rest of his life under a 150-year sentence, but Bernie Madoff is still in the news. This week, we learned that JPMorgan Chase (JPM) is settling charges against it for its supporting role in Bernie Madoff's scam by paying $2.5 billion in penalties.

The investors whom Madoff bilked lost about $17.5 billion in principal. Thanks in large part to bankruptcy trustee Irving Picard, those investors are actually recouping more of their investments than you might have suspected. Picard has recovered more than 50 percent of the lost money -- about $9.5 billion. Adding in the JPMorgan penalty, all told, the total he has regained for those victims is about two-thirds of what they invested in the fund.

That's great for the defrauded folks, but don't let it have you thinking that you, too, might get most of your money back if you fall for some Madoff-like scheme. That's not likely. Instead, learn what red flags you ought to watch out for, so you don't end up a victim.

Heed Warning Signs

JPMorgan itself outlined some of those red flags in its eventual warning about Madoff to U.K. authorities: "The investment performance [of the Madoff funds] is so consistently and significantly ahead of its peers ... as to appear too good to be true -- meaning that it probably is.''

Consistency of returns in an investment is clearly a desirable thing, and you can get it -- in bonds or CDs, for example -- securities that have a fixed interest rate. But stock prices are in constant flux, as is the stock market. In 2013, for example, the S&P 500 gained a whopping 32 percent, whereas in 2008 it shed even more than that -- 37 percent. Madoff, meanwhile, was reportedly returning 1 percent per month, every month, over many years, with never an annual loss. If someone promises you consistent returns stock market, look closely -- or just run away.

That's especially true if the consistent returns are high, as in the case of Madoff's promise. The stock market, over many decades, has averaged an annual return of close to 10 percent. If someone suggests that you'll earn, say, 15 percent or 20 percent regularly, be very skeptical.

%VIRTUAL-WSSCourseInline-908%Warren Buffett is a rare investor who averaged annual returns of 20 percent or more over several decades, but this is key: He never promised such returns. Indeed, students of Buffett will see that he repeatedly urges investors to be realistic, and warns that his future returns will likely be smaller than his past ones, as his company grows ever larger. (Between 1965 and 2010, Buffett's Berkshire Hathaway (BRK-A) averaged 20.2 percent annual growth of its per-share book value, versus just 9.4 percent for the S&P 500. Its average has since, as he foretold, inched below 20 percent.)

Another warning sign of a problematic stock investment is a return that's guaranteed. You might, for example, run across "guaranteed" returns when penny stocks are hyped as part of a pump-and-dump scheme. (Indeed, penny stocks, trading for less than about $5 per share, are almost a guaranteed loss.)

Be wary, too, if there's any "trust me" attitude in the air. Madoff investors were receiving statements from Madoff himself, not from a reputable financial services firm. (He was even collecting their investment dollars personally, not just fees for his services.) Don't even trust your friends or relatives if they urge you to invest in a certain way or with a certain individual. Madoff made money via friends recommending him to other friends. Classic Ponzi schemes often operate that way. In short, don't trust others too easily with your hard-earned money.

And Keep in Mind...

Finally, think critically about any investment proposition you run across. Don't let yourself quickly assume that any one is safe.

In the Madoff case, most accounts were with JPMorgan, which would have made any questioner feel somewhat secure. It can be hard to imagine that one of the world's largest financial institutions would be involved in such shenanigans. But it can happen -- and it did.

The bottom line is that if an investment seems too good to be true, it probably is. Do your own thinking, and avoid investments you don't easily understand. That way, you can avoid falling for the next would-be Madoff.

Longtime Motley Fool contributor Selena Maranjian, whom you can follow on Twitter, owns shares of Berkshire Hathaway and JPMorgan Chase. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway and JPMorgan Chase. Try any of our newsletter services free for 30 days.