Prominent hedge-fund investor John Paulson, who runs the $38 billion Paulson & Co., is having a big headache due to the recent collapse in shares of China forestry company Sino-Forest Corp. The timber company has tumbled 80% since late May, which has resulted in a paper loss of more than $500 million for Mr. Paulson’s firm.

Muddy Waters, LLC (Muddy Waters) issued a research report on its website on 2nd June 2011, alleging fraud against Sino Forest with a “Strong Sell” rating recommendation. Subsequently, the Company’s stock price dropped approximately 21% on the same day.

The plunge of the share price also hits a few other famous agriculture and timber fund, who have substantial holdings of this stock.

Although it is not clear if the allegation is true and what will happen to the stock price, there are 3 lessons we can learn from this event.

Stock Picking is tough for man on the street

I have emphasized countless times that it is extremely difficult to succeed for man on the street in investing by buying individual stocks. Even if you are highly successful and experienced investor, and may seem to get everything right by choosing the stocks, such unforeseen event will happen. And when it happens, the impact is big.

Even if, in the best case scenario, the allegation is subsequently cleared, the company’s credibility is still badly damaged. Its ongoing access to the equity and debt markets to continue its growth will be severely affected.

Last year’s BP oil spill was another perfect example.

Opinion is more powerful than facts

Accepted it or not, an stock analyst’s report can change a company’s fate, be it right or wrong.

If you can recall, Olam International was forced into launching a publicity blitz on in Feb 2011 after CLSA analyst Swati Chopra questioned the firm’s reporting standards and internal controls. The company’s shares had fallen by 13 per cent on the day the report was released.

A similar incident occurred in 2007, when OCBC Investment Research issued a report about Cougar Logistics that caused Cougar’s shares to drop almost 17 per cent over three days. The irony is that it was discovered that the report contained several factual errors. But even the release of an amended report failed to stem the bloodletting.

Diversification can save your day

Sino Forest is approximately 2% of the hedge fund’s holdings managed by John Paulson. In the worse case scenario, while the stock price goes down to zero, the impact to the fund is still limited. I am always amazed to see many investors put their entire retirement funds into a single stock or any other financial instruments.

Investors were not always as lucky as the Hong Kong investors, who can re-coupe their losses from the collapse of minibond. Hong Kong investors lost as much as $2.5bn in the minibond debacle. How much did Singaporeans lost in minibond?

What lessons have you learned from your own stock investing journey?