This question is rarely asked in the investment process and I sometimes wonder why. Let’s use the recent example of JPMorgan/Chase’s announcement of an unexpected loss of $2 billion. Unexpected! That should be the first warning.
The loss occurred because of a financial hedge placed by their London office. Now the amount of $2 billion may seem large and it is, but, it is within a manageable amount for JPMorgan/Chase. They are a large bank and earn more in profit than the total loss of the hedge. By the numbers, the problem appears very manageable. However, an investor really needs to ask themselves some serious questions about continuing to hold or invest in the company. If $2 billion is unexpected, how much more can be unexpected? Do I as an investor really know?
On the surface the risk is statistically, not significant to the extent it will collapse the bank but, it usually is not the information that is known at the time that brings down a company. It most circumstances it is what is discovered later. According to the statistics and numbers, Lehman Brothers was fully capable of managing the positions they had with mortgages and derivatives right up to the phone call on Thursday evening that credit was no longer available to cover overnight positions. By Friday morning the firm did not have enough capital to open the doors. Enron was regarded as the most powerful company in the world until reality came forward showing the financial statements were misleading, even though technically correct and approved by the auditor. Barings Bank, one of the oldest financial institutions in the world was performing flawlessly right up to the point where people started questioning the gains made by a single trader in Singapore and they turned out to actually be losses.
In each situation everyone knew there was information that clearly raised concerns that something might be seriously wrong but, they were hoping all was OK. This information ranged from astronomical gains that were nearly impossible for people to duplicate to financial surprises that stunned the company’s own management. At points like these I like to ask, why should I continue, or take on the risk of the information being worse than expected or not realistically portraying the real situation. The original decision to invest in a stock was based on information and rational decision making. When you find out the original information was flawed or distorted why try to justify staying in the investment. Is it still rational decision making?
Just remember, it is perfectly OK to say, No Thank You. After all, there are plenty of other investment options available. You don’t have to invest in questionable companies or those that wish to hide the truth.