Dirty, Rotten Scoundrels

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Dirty, Rotten Scoundrels
 from SmartMoney University

Don't be rude. There's nothing wrong with listening to your brother-in-law when he starts spouting on about his latest "discovery" in the stock market. But before you plunk down any of your hard-earned money on one of his "can't fail" wonders, consider the story of Canadian mining company Bre-X Minerals.

Stocks aren't always what they seem. When you set out to analyze one, much of the information -- for better or worse -- comes from the company itself. Sure, the financial statements are audited. And there are plenty of laws against fraud. But that's scant protection against a management team bent on lying to you outright.

A few years ago, Bre-X became the hottest stock on the market after company assayers salted a mining property in Indonesia with gold. The excitement over what looked to be a major new find drove Bre-X shares up to nearly 18 times their initial price. Investors who got in early saw $10,000 turn into almost $190,000 over the space of about a year. But when the fraud was discovered, the run on the stock was immediate and brutal. Bre-X shares quickly became worthless and the company eventually filed for bankruptcy.

If Bre-X had been the only stock you'd owned then, you'd be thinking of jumping down a mine shaft yourself right now. But savvy investors never put all their money in a single investment. Instead, they diversify their holdings, investing in at least 10, usually 20, different stocks. Mutual funds typically invest in anywhere from 15 to several hundred companies at once.

What our demonstration shows is that if you'd limited your initial investment in Bre-X to 5% or less of your holdings, you would have been fine. Better than fine, in fact. Assuming your other 19 stocks earned an average return, you would have ended up with a 41% gain after two years. No matter how hot the stock, it always has the potential to blow up. The only way to protect yourself is to diversify, diversify, diversify