How even savvy investors fall prey to frauds

Even tech-savvy and careful investors who are watchful about corporate malpractices and keep track of the distress signs often fall prey to frauds, finds a recent study.

These investors end up tracking the wrong warning signs -- meaning the warning signs they look for are clear only after it is too late to protect their investment, the study found.

"Individual investors get hurt if they own stock in fraudulent companies that cook the books, such as Enron. But we wanted to know how investors think about fraud and whether they try to protect themselves," said lead author Joe Brazel, a professor of accounting at North Carolina State University.

The researchers surveyed 194 experienced, non-professional investors from 38 states about fraud and their investment activity.

They asked if the investors looked for specific red flags that can be indicative of fraudulent activity, such as abnormally high revenue growth, a change in the company's auditor, or the launch of an investigation by the US Securities and Exchange Commission (SEC).

The researchers found two common factors among investors who are concerned about fraud.

First, if investors think corporate fraud is a common practice, they are more likely to place importance on assessing fraud risk when making investment decisions.

Second, investors are more likely to assess fraud risk if they rely primarily on financial statements to make investment decisions, rather than other sources like news reports or advice from professionals.

Most non-professional investors are not diversified and hold shares in only five to 10 companies at a time.

"That means these investors are more likely to get hurt if they hold shares in a fraudulent company," Brazel said.

"We found that 25 percent of all survey respondents had been burned by fraudulent companies."

Another surprise was that investors were relying on late-stage red flags, such as an SEC investigation. The stock may already have dropped in value by the time these red flags appear.

"If you are waiting for an SEC investigation or a lawsuit before selling your shares, you are tracking the wrong red flags," Brazel said.