There are two common mistakes that you can make when you are considering stocks to purchase: (1) being overly suspicious of any targeted firms which causes you to miss out on a feasible investment, or (2) being too naive about a firm, which causes you to invest in a weak stock.

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It is better to err on the side of suspicion. This strategy will not necessarily make you rich, but it may prevent you from becoming poor. Suspicious reduces your exposure to accounting scandals or other risks that could suddenly cause a sharp decline in your portfolio.

This post leads to four rules of safe investment strategy that can provide a defense against deceptive accounting and unethical behavior in financial markets.

 

Rule-1: Be Suspicious Of Your Ability to Value Stocks

Regardless of how much accounting, finance, and math you know, stock price movements are difficult to anticipate. In some cases, your valuation method may be more precise than the methods used by other investors, but it is the entire set of investors that drives the demand for and supply of a stock, and therefore its price.

It is unrealistic to think that you can completely understand the value, risk, or the credibility of a firm just because you study all of its financial statements, even if you understand accounting. However, an assessment of financial statements may at least help you screen out the stocks of firms whose financial statements are confusing. Please correct me if I am wrong.

 

The high-profile accounting fraud cases have made investors more aware that the financial statements reported by firms may be misleading. Some investors have taken the initiative in learning more about detecting accounting fraud. While such an education can be beneficial, it will not necessarily be sufficient for detecting accounting fraud.

One of the most obvious examples is inflating operating earnings by counting some operating expenses as nonrecurring expenses. Yet, even if investors are trained to watch for this type of fraud, they will not have sufficient information to know whether the firm is committing it. Many firms do incur nonrecurring expenses, and should report these expenses in this manner. It is difficult for investors to identify the firms that have shifted some of their operating expenses over to nonrecurring expenses. In fact, investors are not likely to detect accounting fraud at firms other than those that blatantly abuse the accounting standards.

One lesson of the accounting scandals is that we should not make investments that we do not understand. Even if accounting laws are clarified, most of us still will not understand what we are investing in. The varied interpretations of accounting rules will still lead to disagreement among investors regarding the value of stocks. Given our limited valuation abilities, there will still be stocks that are undervalued and stocks that are overvalued.

If you decide to invest in individual stocks, consider buying the stocks of firms whose operations and financial condition are clearly explained in financial statements and reports. Then, once you screen your list of stocks and identify those with more transparent operations, you can attempt to conduct your own valuations in the search of stocks that are undervalued, or at least are not overvalued.

 

Rule-2: Be Suspicious Of Investment Advice

Just because “experts” in the stock market or many of a company’s employees invest in a stock does not guarantee that the firm’s accounting can be trusted.

You may still remember that many institutional investors had very large investments in Enron stock up to the day the company went bankrupt. Many employees of Enron also had confidence in Enron stock, and lost most of their retirement funds because their pension was concentrated in that stock. If a firm’s executives want to disguise the firm’s financial condition, they can probably achieve their goal within current accounting guidelines.

Just as you have limitations when making investment decisions, so do investment advisers. Research has shown that, in general, professional portfolio managers have not outperformed stock market indexes. In addition, analyst ratings have not been accurate predictors of stock price movements.

 

Rule-3: Be Suspicious Of a Firm’s Management

There are thousands of stocks available, so there is no reason to invest in a stock unless you feel confident that the firm’s management is not only efficient but also ethical. Be alert for possible unethical behavior that can adversely affect the stock price. The accounting scandals provide numerous valuable lessons. Don’t trust anyone when making investment decisions, including the firm’s executives, its board members, and its auditors.

The scandals do not mean that all stocks are overvalued, but they do mean that investors must be very cautious when selecting stocks. Investing in stocks can be sensible even for conservative investors, assuming that they invest within their information boundaries. If you want to gamble your money by undertaking risky strategies within the stock market, at least recognize the risk involved.

 

While the accounting scandals may ultimately result in greater regulation and enforcement, investors cannot assume that regulations will prevent other scandals in the future. While there are many reputable executives, board members, and auditors in the business world, it is difficult to distinguish those who are reputable from those who are not.

Even if there is more monitoring to ensure that the accounting is within the guidelines, the accounting rules still allow substantial flexibility. Consequently, some firms will still create misleading financial statements.

 

In addition, there are still conflicts of interest that encourage a firm’s executives, accountants, directors, and independent auditors to create or allow misleading financial statements. The most obvious example of this is when a firm uses accounting that is misleading, although it is within the rules, simply because other firms in the industry use the same type of accounting. This form of deceptive accounting will continue until the accounting standards are narrowed in a way that forces each firm to be more honest. As it stands, some firms feel forced to exaggerate their numbers within the rules just to keep up with the accounting used by their competitors.

There will still be firms that will try to inflate their stock’s value, at least for a temporary period. There will still be executives who try to sell their shares while the stock is overvalued. There will still be analysts who rate stocks highly because of conflicts of interest. There will still be auditors who sign off on financial statements that are technically within the accounting guidelines, but are misleading to investors. There will still be board members who are unable to detect fraud by executives or auditors, or who are unwilling to report it. There will still be investors who will be adversely affected by all these actions.

Also recognize that even if a firm’s managers are ethical, they may not necessarily be competent. In a fiercely competitive business world, many business ideas will fail. Even some firms with good business ideas struggle because they do not implement their business ideas efficiently. Their high cost of producing their products or services is essentially passed on to the shareholders.

 

Rule-4: Limit Your Trust In Any Particular Stock

If you buy individual stocks, you should buy a sufficient number so that you are well diversified. Some research suggests that you need at least 12 or 15 stocks to be well diversified. However, it is dangerous to generalize, since the effects of diversification are dependent on the mix of stocks that you consider.

Example:

If you purchase 100 technology stocks, you are not well diversified because a decline in the technology sector will cause major damage to your stock portfolio. Since stock prices can change in an unpredictable manner, your stock portfolio is at risk. If you recognize your limitations, you can establish a diversified asset allocation (among different types of securities) that is less vulnerable to unanticipated swings in stock prices. Do not place too much trust in any one stock. Limit the amount of funds that you can lose as a result of possible deceptive accounting or unethical managerial behavior by individuals employed by a firm.

You may be astute enough or lucky enough to avoid being cheated by executives, accountants, board members, or auditors. But if you prefer to reduce your exposure to the possibility of being cheated, you should consider investing in a broadly diversified stock portfolio. You can easily achieve broad diversification by investing in mutual funds or exchange-traded funds.