Money Sundays: How To Avoid the Next Enron (or WorldCom, or Theranos, or Toys R Us, or ...)

A reader asks:

How can one avoid buying or owning a stock that goes badly south a la Enron?

Three thoughts:

1) Learn to read financial statements. At the very least, learn to read them to a basic level such that you can make sure a company's cash flows from operations match up with (or better yet, exceed) net income on its income statement. The issue with Enron is that the cash didn't add up: the negative operating cash flows on Enron's cash flow statement didn't make sense when compared to the positive earnings on the company's income statement. This suggested earnings were being exaggerated somehow and simply weren't legit. Also, learn to read a balance sheet, and know how to differentiate a "good" balance sheet from a "bad" balance sheet. This might mean taking a intro to managerial accounting class, or getting a couple books out on financial statement analysis. Generally you'll want to stick to investing in companies with good (or better yet, great) balance sheets, preferably choosing companies that also pay consistent dividends. Note: It's okay to speculate in riskier companies, just don't do it with investment capital you depend on.

2) Avoid cult stocks, avoid overly popular stocks and avoid popular sectors. Don't get sucked in. Pay attention to which names "everybody" talks about, and if any stock you already hold becomes too popular or too widely held, cut it back. Think about it: Once everybody owns a stock, who's left to buy more? Also, it can really help to have friends and acquaintances across a spectrum of investment experience and sophistication here, and it helps to read publications across a spectrum of investing sophistication too. An example: if you see a stock you own mentioned bullishly on, say, the Motley Fool website, you should consider trimming it back. And if you see a stock you own mentioned bullishly in People Magazine... run. Likewise, if you have a few acquaintances who previously had no experience in--or interest in--investing, and they suddenly start buying up tech stocks like it's 1999 and they can't seem to shut up about them, that's a potential sign about future investment returns in that sector. It could also be a sign about the (likely very poor) investment potential of the entire stock market.

3) Final thought: you can't really avoid all possible instances where an investment goes badly south. It will still happen to you on occasion, even if you follow all these rules. That's the game: sometimes stocks go down, and sometimes they go down a lot. Therefore, be a second order thinker: let your understanding about this always-present risk inform your investment decision-making in the first place. Let it keep you humble as an investor, and let it drive you to select a range of different ways to protect your investment capital (e.g., have smaller position sizes, own more stocks, stick to mostly great companies with great balance sheets, hold larger cash positions, buy stocks only with long term money you don't need in the near term, etc.).

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