Lessons for investors from fraud and bankruptcy

The importance of considering the consequences.

While Greece and Spain were grabbing the financial headlines recently, two other high-profile financial stories were also getting a lot of attention for very different reasons.

The first concerned the disgraced financier Allen Stanford, who was sentenced to 110 years without parole by a court in Houston for running a US$7 billion Ponzi scheme, which wiped out the life savings of many of his investors. The second was that Shane Filan, a member of the boy band Westlife, had filed for bankruptcy because of the failure of his Irish property development company.

Investors can learn three very important lessons from these stories. Don't put your life savings into a single investment — if something looks too good to be true then it probably is — and don't borrow too much.

Cricket, lovely cricket

Stanford made his name in the early 1980s by buying up depressed property in the wake of the Texas oil bust. He then moved to Montserrat and founded a bank that grew into the multi-billion dollar Stanford Financial Group.

Then in 1991, after the American and British governments cracked down upon Montserrat's shady banking practices, Stanford relocated to Antigua. His importance to Antigua's economy can be seen in the fact that many locals used to call him the King of Antigua, while Stanford Financial Group was the largest private-sector employer on the island by a long way.

Stanford did most of his business in the Americas and he wasn't well known in Britain until he sponsored an international Twenty20 cricket competition between England and the West Indies in 2008, where the winning team would each receive US$1 million while the losers got nothing.

The warning signs

Stanford's opulent lifestyle, his talent for self-promotion, the fact that Antigua had all but become a subsidiary of his business empire and those scenes of him cavorting with the England players' wives and girlfriends should have set off all sorts of warning bells among his investors.

That sort of behaviour is acceptable in some industries, especially entertainment, but not in finance where you want to entrust your money to someone like Captain Mainwaring of Dad's Army fame or the stereotypical accountant for whom wearing brown shoes instead of black would be a radical fashion statement.

If a financier ever reminds you of Minder's Arthur Daly or the Trotter family in Only Fools and Horses, run a mile. And if they are offering rates of return that are well above what the rest of the market is paying, as Stanford was, ask yourself how can they do this without taking on more risk?

Safe as houses?

When it comes to music, my interests pretty much stopped in the 1980s.So I was only dimly aware that there was a band called Westlife.

But when I read the reports of Filan's bankruptcy I delved a little deeper. It turns out that Westlife are thought to have made over £30 million and Filan had geared up his share by borrowing a lot of money and piling into Irish property development at a time when many people thought that this was a one-way ticket to even greater riches.

When it feels as if everyone is piling into a particular type of asset, and many are doing so with borrowed money, it's probably a good idea to be somewhere else unless you can afford to take the hit when it goes wrong. You'll miss out on some excitement, but sooner or later it will all end in tears.

Why you should diversify

Every time there's a financial scandal like Stanford, and the even-larger Ponzi scheme operated by Bernie Madoff, it turns out that some people will have been wiped out because they put their life savings into a single investment.

You can afford this level of concentration if you're starting off your investment career at a fairly young age, particularly if you've got a decent job and few commitments. But as you grow older it's crazy to put all of your eggs in one investment basket, even a company that's as financially rock-solid as Warren Buffett's conglomerate Berkshire Hathaway (NYSE: BRK-B).

Investors need to avoid excessive optimism and diversify by asset class, country and sector while always being suspicious of promises of above-market 'guaranteed' returns. But diversification doesn't just mean investing in several different companies that operate in the same sector of the economy, as all this does is diversify away from company-specific risk and leaves you with country-specific and sector-specific risk.

The fallback position

No-one goes into an investment with the intention of losing money. But every time you invest in something, you should consider the likelihood of things going wrong and the consequences if it does.

A massive company like Unilever (LSE: ULVR), which operates in over a hundred countries and has a large range of branded products that consumers keep buying in most market conditions, is fairly well diversified in its own right. But it is still only one company, so it is exposed to company-specific risk — such as if a new management team decided to take on massive debts to engage in some questionable empire building.

An easier way is to diversify is to invest in many different companies as well as index-tracking funds and international investment trusts. I've increased my diversification over the last decade to the point where I now own shares in 45 different companies, with 15% of the portfolio being in investment trusts and 80% in companies that mostly operate outside Britain. Even so, I'm still very overweight in distilleries, oil and North American railroads.

It won't ever reach the spectacular returns that can sometimes be obtained by "betting the farm" on a single investment, but at least it lets me sleep at night!