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How Will Goldman's Fraud Charges Affect Your Investments?

How Will Goldman’s Fraud Charges Affect Your Investments?
Ron DeLegge
April 22, 2010

SAN DIEGO (ETFguide.com) – Sometimes giants get too big for themselves. In outer space, for example, when a large star explodes it creates a massive interstellar tsunami. Shortly thereafter, the star becomes just a shadow of its former glory.

On Wall Street, Goldman Sachs (NYSE: GS) is today’s banking star but civil charges of fraud by the Securities and Exchange Commission (SEC) threaten both its reputation and its future. If you own Goldman Sachs’ stock directly or via a mutual fund or exchange-traded fund (ETF) what impact will it have upon your investments?

Before we answer that question, let’s analyze stars of the past, who like Goldman, were thought to be invincible.

Is this Goldman’s Future?
Drexel Burnham Lambert was once a top Wall Street investment banker with a storied history, not unlike Goldman Sachs. The firm was started by I.W. “Tubby” Burnham in 1935 with a $100,000 investment. The firm’s original focus was on retail brokerage but eventually it expanded into investment banking and 

In 1986, Drexel’s fortunes quickly reversed when one of its managing directors (Dennis Levine) was charged with insider trading. After two long years of steadfast denials, the SEC sued Drexel for manipulating securities, insider trading and defrauding its clients. By 1990, the one-time Wall Street giant Drexel Burnham Lambert was forced into bankruptcy. Few predicted this humbling conclusion and even fewer thought that it was possible.

While Drexel’s fraud conviction didn’t lead to its immediate demise, it was undoubtedly a contributing factor to the firm’s demise. Is this Goldman Sachs’ future?  

Understanding Risk
Too many investors still don’t understand the risk of investing in individual securities nor do they understand how to minimize it. Let’s help them.

Whether you buy an individual stock or individual bond you’re making a deliberate bet that that specific security will outperform the market. You may be right or you may be wrong, but the odds of success aren’t with you.

Even after conducting extensive research, most professional investors still see their carefully selected picks beaten by brainless index funds and ETFs. Now you know why CNBC’s Jim Cramer never compares any of his collective stock picks to the performance of corresponding index funds.

Furthermore, your investment success or failure in individual stocks or bonds is directly affected by all actions and decisions of the company’s management team. Even though you feel your company’s management team is the best around, how do you really know? Wasn’t it Warren Buffett, the world’s greatest stock picker, who said he invested in Goldman Sachs because of its management’s “integrity?” And if Buffett can’t always distinguish the difference between ethical management teams versus rotten ones, can you? 

Get out the Microscope
Over the past five years, Goldman Sachs has splendidly outperformed brokerage (NYSEArca: IAI) and financial stocks (NYSEArca: XLF) within its own industry sector. However, over the past year it’s underperformed S&P financials and moreover, Goldman’s future as an invincible investment banking star is in serious jeopardy.

For the rest of the financial sector, the SEC’s fraud charges against Goldman are problematic too. Having already faced a firestorm of scrutiny from the 2008-09 Credit Crisis, more attention and more financial regulation are the last things the financial sector wants.  

Conclusion
If your investment portfolio has too much single stock risk now is the time to act. Evaluate your mutual funds too. If they are over-concentrated on just a handful of stocks, it may be time to switch to something more broadly diversified. You’re financial well-being is too important to ignore. Be proactive andbe deliberate. Look for ways to reduce your risk by diversifying.

Individual stocks come and go, but industry sectors with a real economic purpose always survive. And a low cost index fund or ETF is the easiest way to capitalize. Minimize your risk while still staying invested.  

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