How to Protect Against Investment Fraud?  Diversify

Suzanna De Baca -- Expert Business Source, 6/25/2008 7:30:00 AM

Last Thursday, two Bear Stearns hedge fund managers ended up in a Brooklyn jail cell after being indicted on securities fraud charges.  The two men are the first Wall Street executives to be indicted on charges related to the credit crisis, including failure to communicate the precarious state of their fund and its risk of collapse to their investors.  As an investor, you can research to determine whether a company is healthy or not, but how can you ever detect – and then prevent—fraud?

There is a long string of securities and investment fraud lining our history.  Enron tops the list in recent history, but it has had plenty of company over the years.  In many cases, even the auditors were unaware of the deceitful dealings.  Certainly large firms have legal and compliance departments, which beg the question: “If they can’t predict fraud, how can you?  And if you can’t predict it, how can you protect against it?

You can’t.  You could be the best investigator and analyst in the world, but people who want to hide shady business do a good job of covering their tracks.  But one way to prevent fraud from affecting your entire portfolio and threatening your total financial security is to diversify your investments.

How do you diversify?

It doesn’t matter what size your portfolio is.  Diversification is equally important for the average working person who pumps money into a modest retirement plan as for the high net worth individual who routinely invests in unregulated investments like hedge funds. The difference will be in how you diversify.

If you have a portfolio of individual securities, you should own enough to protect against the decline of one stock or bond.  Many experts recommend holding at least 25 stocks in fairly equal proportions and rebalancing if one holding gets too large.  You may question why you’d want to trim a winner, but if that one holding starts to make up too large a portion of your net worth and then gets hit—by fraud or declines – your entire portfolio suffers proportionately as well.

For mutual fund investors, the fund itself provides diversification because it is a pool of stocks, bond, or cash equivalents.  Most often, however, a fund invests in one asset class such as large cap stocks, mid cap stocks or international stocks.  Diversifying with mutual funds means having a selection of asset classes, so if large cap stocks have a bad year you will have some other exposure to asset classes that have held up better.  If one particular fund experiences fraud, you’ll have the others to protect your overall portfolio.  Advisors generally recommend that depending on the size of your portfolio, at minimum you should own large, medium and small cap stocks or bonds, a blend of growth and value, and have international exposure.

A hedge fund investor should also consider having a number of funds, or investing in a fund of funds, to sufficiently diversify or to keep any one investment from tanking the entire portfolio.  Similarly, if you have other alternative investments, such as private equity, venture capital, real estate, oil and gas or other private partnerships, limit your exposure to any one holding and realize that with these unregulated investments you are open to risk.

If you are the victim of securities fraud, there are various avenues you can pursue to try and recover funds.  However, diversification is one way you can prevent fraud from affecting your entire portfolio.

Suzanna de Baca is president of Private Capital Solutions Group. Securities offered through Broker Dealer Financial Services Corp. Member FINRA & SIPC. Investment Advisor Representative of Investment Advisors Corp., A Registered Investment Advisor. Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal or investment advice. Although the information has been gathered from sources believed reliable, please note that individual situations can vary, therefore the information should be relied upon when coordinated with individual professional advice.