Fraud Scares Off Stock Investors

The evidence is clear: fraud causes investors to shed their shares of stock.

When the stock market is booming, fraud swirls unnoticed beneath the frothy surface.  Only when the market busts, as it did in the fall of 2008, are allegations of fraud and financial shenanigans exposed to the public.

When they are, and rattled investors realize what has taken place, they decrease their stock holdings – whether they own shares in any of the fraudulent companies or not – according to researchers in Stockholm and at the University of Minnesota.

Their study analyzed changes in equity holdings among U.S. households in response to more than 700 Securities and Exchange Commission charges and other reports of fraud from 1984 through 2009.  The researchers focused on investors state by state, based on the assumption that allegations of fraud at local companies were more visible and would be more likely to affect an investor’s decisions.  They also controlled for economic effects, which can influence investors’ decisions.

Their findings are:

• Reports of fraud in a given state made investors in that state less likely to hold stocks.
• The more intense the fraud, the higher the probability households will sell stocks.
• The demise of Arthur Andersen, which audited Enron Corp., had an impact: in states with more of the accounting firm’s clients, investors were more likely to reduce their stock holdings in the wake of Enron’s spectacular demise.
• Households were affected by fraud and reduced their stock holdings even if they did not own the stock of any companies charged with fraud.

The global financial collapse is receding into the past, but the effects are longer term.