In August of 2000, the energy company, Enron, posted a peak stock price of $90.75 per share. At the time, Enron was one of the largest companies in the United States. It wasn’t an “obvious” shady scam; everyone thought it was a great investing opportunity.
With over 20,600 employees and headed by executives with impressive resumes, Enron was dubbed a “darling of Wall Street” as the stock only seemed to go up.1Source: Time
But all that ended when Enron’s executives were found to be committing accounting fraud. And the stock price dropped to $0.26 per share in November 2001.2Source: Jct.gov
A dog that looks like a duck is still a dog
A Fortune magazine writer who covered the Enron scandal spoke to an employee who explained how the fraud was done.
Here’s how the employee put it:3Source: Acquirers Multiple
“Say you have a dog, but you need to create a duck on the financial statements. Fortunately, there are specific accounting rules for what constitutes a duck: yellow feet, white covering, orange beak.
So you take the dog and paint its feet yellow and its fur white and you paste an orange plastic beak on its nose, and then you say to your accountants, `This is a duck! Don’t you agree that it’s a duck?’
And the accountants say, `Yes, according to the rules, this is a duck.’ Everybody knows that it’s a dog, not a duck, but that doesn’t matter, because you’ve met the rules for calling it a duck.”
That’s just the thing when it comes to white-collar crime, which involves a lot of investment fraud. Companies use accounting flexibility to make their company grow on paper. Even if it’s slowly sinking into reality.
And unless you want to spend time and effort looking at the balance sheets of companies you want to invest in — Investing in individual stocks is not recommendable.
Because these are the things that people often miss when they invest in a hurry based on a “stock tip.”
I’m not going to sit here and say I’m immune to that stuff. I’ve poured tens of thousands of dollars into a stock after reading a few articles. Those investments didn’t go well for me. You can’t make a decision to invest your money in a few minutes.
Look at the primary source
While most people lost money when Enron’s stock fell, one of the biggest winners in the scandal was an investor who shorted (bet against) the stock.
James Chanos and his investment firm specialized in studying companies that were overvalued. And they shorted these companies’ stock, anticipating that the price would eventually fall.
Chanos’ firm shorted Enron stock in November 2000. When Enron’s stock fell, Chanos and his firm pocketed hundreds of millions from the trade.4Source: Investopedia
Chanos put it well when he said:5Source: Business Insider
“Primary research is crucial and not as many people do it as you think… So I teach my students and analysts: start first with the SEC filings, then go to press releases, then go to earnings calls and other research. Work your way out. Most people work their way in.”
This advice applies not just to investing but to a lot of things we do in life.
Whether you’re checking a person’s credentials or you’re shopping for a new house, you’re safer when you look at the most unbiased sources first. And the most “unbiased” source you can get is the primary source.
- A friend recommended an “investment opportunity” for you? Research that investment independently. Even if you trust the friend who made the recommendation.
- A credible news site told you that AI is projected to make trillions of dollars within a few years. And you want to get in on the action? Give yourself basic knowledge about investing in AI first.
- Want to build an online business selling digital products because it’s supposedly a great way to “make money in your sleep”? Check which online businesses actually make a sustainable income. And learn the overview of their working process.
Always verify things as much as you can. You’ll thank yourself later for it.
Investing in individual stocks is not easy. Common platitudes like, “If you own the product, own the company,” don’t always work.
Good companies are not always good investments. I can go on and on about all the paradoxes of investing, but you get the point.
Simply remember this: Things are never as obvious as they seem in finance.
Avoid investing when you’ve just lost money
People who lose their investments tend to lose even more over time. As if they “haven’t learned their lesson.” But there is a psychological aspect to the trend of continuously losing money.
Robert Cialdini, author of the book, New-Influence: The Psychology Of Persuasion, explained to Forbes why smart people get fooled into investment scams.6Source: Fobres And why you’ll want to avoid investing when you’ve just lost money.
“When people are dealing with recent experiences where they’ve not done well, they don’t want to lose anymore. So you can tell them that unless they move, they’re going to lose the opportunity.”
A lot of scams operate on a sense of scarcity (“Buy now while the opportunity is still open!”). And when people have just lost money, they may feel a strong need to recuperate their losses as soon as possible.
Cialdini saw this firsthand when he studied phone scams that targeted the elderly.
“They [the elderly] get burned and are so ashamed that they become vulnerable to the next scam so they can recoup their losses. They don’t want to think of themselves as losers and they don’t want their family to think of them as fools and idiots financially. So they wind up getting in again and losing yet another chunk of their savings.”
It’s a matter of self-awareness.
Ask yourself: Do you understand what you’re investing in? And does it make sense?
Generating wealth has an underlying mechanism. And that’s value.
Create value. Make money.
But the problem with investing scams is that they don’t generate value. Once you understand that, you will be able to poke holes in investing opportunities that make no sense.
You will no longer be a good victim for scammers and they’ll leave you alone.
Stick to what you know and what has worked. You might not get rich quickly, but at least you will not lose all your money.
