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I have lost money in US/German stock market due to the accounting and other frauds committed by some companies. I am wondering if there is any way to detect such potential fraud before investing or anything can be done as a shareholder.

For example blue chip companies like Volkswagen, Porsche etc. lost ~50% stock value due to cheating. Joyou went bankrupt due to accounting fraud (nothing happened to its parent Lixil).

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  • That seems a pretty bold claim. Can you point to some examples in the media? That might also give us a clue as to what sort of things you should look for.
    – Peter K.
    Oct 21, 2015 at 12:25
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    If the type of fraud exemplified by Volkswagen was detectable prior to investing, then Volkswagen would not have lost half of its market capitalization when it became known. Lots of very smart people spend lots of time looking at companies from every available angle before investing; the odds that you would do significantly better as a private individual are slim.
    – user
    Oct 21, 2015 at 18:13
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    Golden rule no 1: DIVERSIFICATION. Just don't put all eggs in one basket. That's all, and the best thing at that, you can do to protect yourself against such situations.
    – vic
    Oct 21, 2015 at 20:40

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Given that such activities are criminal and the people committing them have to hide them from the law, it's very unlikely that an investor could detect them, let alone one from a different country.

The only things that can realistically help is to keep in mind the adage "If something sounds too good to be true, it probably is", and to stick to relatively large companies, since they have more auditing requirements and fraud is much harder to hide at scale (but not impossible, see Enron).

Edit: and, of course, diversify. This kind of thing is rare, and not systematic, so diversification is a very good protection.

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    How about blue chips like VW, Toshiba etc.?
    – pappu
    Oct 21, 2015 at 16:51
  • @pappu: absolutely nothing you can do there, realistically. Oct 21, 2015 at 17:01
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    @pappu: They're not magicians. They do what they can, but they can't detect everything. Oct 21, 2015 at 17:57
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    While fraud detection is likely beyond the resources of individual investors as Michael suggests. One solution is to invest broadly across the market so when the few events do happen they only have a tiny effect on your overall portfolio.
    – rhaskett
    Oct 21, 2015 at 20:21
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    @pappu They are legitimate companies. There is a risk with investing in stocks - this is one type of that risk ;)
    – Ross
    Oct 21, 2015 at 21:33
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Most of the information we get about how a company is running its business, in any market, comes from the company. If the information is related to financial statements, it is checked by an external audit, and then provided to the public through official channels. All of these controls are meant to make it very unlikely for a firm to commit fraud or to cook its books. In that sense the controls are successful, very few firms provide fraudulent information to the public compared with the thousands of companies that list in stock markets around the world.

Now, there is still a handful of firms that have committed fraud, and it is probable that a few firms are committing fraud right now. But, these companies go to great lengths to keep information about their fraud hidden from both the public and the authorities. All of these factors contribute to such frauds being black swan events to the outside observer.

A black swan event is an event that is highly improbable, impossible to foresee with the information available before the event (it can only be analyzed in retrospect), and it has very large impact. The classification of an event as a black swan depends on your perspective. E.g. the Enron collapse was not as unexpected to the Enron executives as it was to its investors.

You cannot foresee black swan events, but there are a few strategies that allow you to insure yourself against them. One such strategy is buying out of the money puts in the stocks where you have an investment, the idea being that in the event of a crash - due to fraud or whatever other reason - the profits in your puts would offset the loses on the stock. This strategy however suffers from time and loses a little money every day that the black swan doesn't show up, thanks to theta decay.

So while it is not possible to detect fraud before investing, or at least not feasible with the resources and information available to the average investor, it is possible to obtain some degree of protection against it, at a cost. Whether that cost is too high or not, is the million dollar question.

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  • Have you tried such strategy? The premiums+commissions for buying put options can eat away all the profits from the stocks. Also there could be counter party risk in case of black swan event.
    – pappu
    Oct 21, 2015 at 17:43
  • the black swan funds that implement these type of strategies can go under if nothing happens for a long enough time. They must take deep out of the money puts in order to keep the premiums in check, and operate a large portfolio to keep the commissions low on each trade. But even then its a strategy that dies every day a little bit with the hope of making one huge homerun.
    – PabTorre
    Oct 22, 2015 at 3:04
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    @PabTorre: Yep. Like everything else in the market, potential for gains is balanced by risk of losses. Long-term diversified investing is a positive sum game. Most other games you can play with the market are zero-sum minus commissions... And if you don't see the sucker at the poker table, he's sitting in your chair.
    – keshlam
    Feb 16, 2017 at 13:48
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Even without fraud, a company can get into serious trouble overnight, often through no fault of their own. That's part of the hazard of being part owner of a company -- which is what a share of stock is.

As a minority owner not involved in actually running the business, there really isn't a lot you can do about that excep to play the odds and think about how that risk compares to the profit you're taking (which is one reason the current emphasis on stock price rather than dividends is considered a departure from traditional investing) and, as everyone else has said, avoid putting too much of your wealth in one place.

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