ONE day all is well. The next day, without warning, a company reports huge losses.

Yes, it has happened again. Twelve years ago there was Nick Leeson and Barings. Two years ago we had China Aviation Oil. Both played a dangerous game - derivatives trading.

In the latest financial fiasco, Sembcorp Marine (SembMarine for short) announced that a senior officer had tried his luck with derivatives. No luck. So far, the unauthorised trades have racked up $362 million in losses.

The company is majority owned by Sembawang Corp, which in turn is 49 per cent owned by Temasek Holdings. Neither is involved in SembMarine's operations.

Derivatives are futures, options, swaps and warrants. Used correctly, they decrease risk by hedging.

Incorrectly, they can increase risks through speculation.

Like China Aviation Oil, SembMarine said in its annual report that it only hedged. That may no longer be accurate.

Combined one-day losses for all SembMarine shareholders totalled $1.8 billion. It's a lot to lose in a day.

But the SembMarine loss is only 10th among the top financial disasters of the past 20 years. (See table below.)

Will it happen again? Probably. So how can you guard against big losses?

As I see it, there is only one way.

Eggs in many baskets

To figure out if a company is in trouble, you need to dig, dig, dig into its annual report.

But even if you dig, can you find the dirt? After all, the auditors failed. And they are certified public accountants with access to the company's data.

My suggestion - don't bother to analyse all those financial statements.

Instead, accept the fact that you will take a hit now and then. Don't fight it. Just reduce the damage.

How? Diversify. There are two ways to do it.

One is to reduce the risk of ups and downs in share prices.

You only need 15 to 20 counters to eliminate 90 percent of fluctuations in your portfolio.

Bonds do the best job. Combining them with stocks is a perfect match. One goes up when the other comes down. It converts a wild, gyrating portfolio to a tranquil one.

The second type of risk is that a company will go broke (like Enron) or suffer unexpected  losses (like SembMarine). To reduce that risk, you need to hold hundreds of stocks.

The only practical way is to buy a fund, like a unit trust. The problem is that they are expensive, with high annual expenses and hidden costs.

Don't despair. There is a new type of fund called an exchange-traded fund (ETF). It has very low expenses and is a wonderful way to invest. You buy them through a broker, like a stock.

We have 17 ETFs listed on the Singapore Exchange. Only one stock ETF is eligible for investing CPF money. It is the STI ETF, which tracks the Straits Times Index.   

(i) LTCM is Long-Term Capital Management (ii) The letter 'd' means derivatives were involved (iii) Parmalat's losses were also tied to a subsidiary in Singapore

Do auditors feel the heat?

IT'S the law. Publicly listed companies must be audited.

Auditors nearly always give a 'clean opinion', which means it found no problems with the company's accounting.

The phrasing is nearly identical for all audits. It says: "The financial statements give a true and fair view of the state of affairs of the Company. The accounting and other records have been properly kept."

I often ask auditors to comment, especially when something went wrong at the company.

The response is always the same: "We are unable to comment due to client confidentiality."

Aha. That one sentence reply reveals more than you think. It shows the auditor has a client. It works for the client. It is paid by the client.

Whoa. Isn't that a huge conflict? The auditor polices the client. If its accounting does not conform to generally accepted accounting principles, it is supposed to blow the whistle.

But the company it audits is also its paymaster.

Does this conflict of interest result in auditors issuing clean opinions too easily?

I think so. Each of the 10 financial failures in the table had received clean audit opinions.

It is a worldwide problem and has been around for a long time. So far, no one has come up with a solution.

What are the penalties for auditors who fail? Enron and WorldCom's auditors, Arthur Andersen, declared bankruptcy rather than face investor lawsuits.

Our auditors are not under that kind of stress. They can simply say 'sorry' and walk away with no worries about investor lawsuits.

No auditor in Singapore has ever been successfully sued for its failure to discover errors in accounting statements.

Is this article useful to you?