The stock market is known as a place to build, maintain, and grow wealth. With protections provided by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), it’s natural to assume that an investment made in the stock market is safe from fraud.
Unfortunately, that’s the same assumption investors in Enron made.
Although fraud doesn’t run as rampant as it once did in the stock market, it still exists and likely always will. As long as there are vast amounts of money flowing through the market, there will be crooks who look for ways to steal it.
One of the most common forms of fraud in the stock market today is known as the pump-and-dump scheme. Through these schemes, fraudsters steal hundreds of thousands and even millions of dollars from investors with short-term trades designed to do just that — steal value out of unsuspecting investor portfolios.
What Is a Pump-and-Dump Scheme?
A pump-and-dump scheme starts with a relatively large investment in a relatively unknown stock. Generally, these stocks trade in the penny-stock category and seriously lack credibility. The targets of pump-and-dump schemes are also known to have relatively low floats, leading to the potential for excessive volatility, or dramatic runs in value.
Once they make a large investment, the con artist behind the scheme starts to disseminate completely false statements, half-truths, and other misleading information touting the company around the web, often paying thousands of dollars in advertising costs to ensure that the misleading information reaches the masses.
As the investing community begins to read the lies made by the fraudster behind the scheme, a mass of investors make large investments in the company, hoping to strike it big on the newly found information. The glut of buying pumps the stock’s price up.
The only problem is, the information about the strength of the company is false.
Once the stock reaches what the pump-and-dumper believes is the top price for the run, the fraudster exits his position, dumping hundreds of thousands of shares back into the market and leading to a fast-paced reversal.
By the time the average investor realizes what’s going on, the schemer has cashed in on hundreds of thousands or millions of dollars in profits that were essentially stolen from the investing public.
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Why Pump-and-Dump Schemes Are So Dangerous
Pump-and-dump schemes, like all forms of stock market fraud, are incredibly dangerous for several reasons.
They Target Gullible Investors
The primary target for pump-and-dump schemes are investors that lack the ability, the time, or the willingness to do deep research into their investments. For lack of a better term, pump-and-dump schemes target gullible investors.
The investors who fall into this category of fraud are usually beginner investors or retirees who simply don’t have the wherewithal to sniff out the scheme. Unfortunately, these are the investors who are damaged the most when struck by fraud.
Elderly investors who rely on income from their portfolios simply don’t have the time horizon needed to recover from victimization in the stock market. At the other end of the spectrum, beginners who take big losses are often deterred from making future investments in the stock market, leading to delayed entrances for retirement plans and costing the investor hundreds of thousands or even millions in compound gains over the rest of their lifetime.
Either way you look at it, the victimized investors are left with devastated portfolios and long-standing negative side effects.
They Cost Investors
Pump-and-dump schemes are not small schemes. The fraudsters that take part in them know they face jail time and massive fines if the SEC becomes aware of what they’re doing. So, they’re not taking that risk for chump change.
In fact, a study cited by Quartz found that pump-and-dump schemes result in between $3 billion and $10 billion in losses annually. That’s a massive loss of value, leading to tremendous pain for any investor caught in the path of these fraudsters.
They Lead to a Lack of Trust Among Investors
The only way the stock market works is if it provides a fair and equitable marketplace for all involved. As a result, the investing population’s trust in the market and the regulators that look over it are overwhelmingly important to its success.
When fraudsters victimize hundreds or even thousands of investors in a pump-and-dump scheme, those who fall victim to the scheme tend to lose trust in the system. That’s not only a bad thing for those investors, that’s a bad thing for the system as a whole that relies on this trust for its future success.
Tips for Identifying a Pump-and-Dump Scheme
If you’re looking for momentous opportunities in the stock market, especially in the penny-stocks corner of the market, it’s important that you are able to identify and stay clear of the pump-and-dump schemes you may come across. Here are a few tips to help you do just that:
Pay Attention to Who Released the Information
The internet is accessible to everyone, and building a website isn’t difficult. All you need is a few dollars and an idea. It’s important to keep that in mind when researching your investment opportunities online.
When reading new information that suggests a company is going to see dramatic gains, it’s important to make sure that the information is released by either the company itself or the investor relations firm that represents the company.
Oftentimes, finding a bad actor is as easy as looking at the name of the author who wrote the article that caught your attention. If it was the company or its investor relations firm, it will be published as an SEC filing or a press release with clear contact information naming the company that issued the news or the investor relations firm that represents them.
If news is released by any other party, it’s a rumor at best. At worst, it’s a pump-and-dump scheme in the making. Either way, if new information comes from any party other than the company or the investor relations firm that represents it, the information should not be trusted and requires further verification.
Only Trust News on Trusted Websites
Acquisitions are some of the highest-value transactions in the stock market, and rumors of them tend to lead to big moves. In some cases, members of the media will become privy to a potential acquisition prior to it being announced by the company. While investing in an acquisition rumor is a risky play, it’s not always a setup for fraud. In fact, some investors scour message boards looking for opportunities to profit off of these types of rumors by getting in first.
Unfortunately, knowing this, fraudsters often release acquisition rumors in hopes of triggering a pump-and-dump opportunity.
So, if you’re chasing acquisitions as part of your strategy or making other speculative bets, only trust information and analysis that was published by major members of the media. For example, Forbes, Business Insider, Zacks, and CNN cover acquisition rumors from time to time but have the clout and research ability to make sure that the rumors and other speculation-driven stories they cover are not part of a pump-and-dump scheme.
Research and Verify All Information
Third-party investors often share their stories and opinions with the investing community, and it’s OK to look to others to find great investing ideas. However, it’s never a good idea to blindly trust the author of an article, video, or any other piece of content.
When researching an investment opportunity, it’s best to verify all information you come across that was not published by the company itself or the investor relations firm that represents it. To do so, simply go to the investor relations website for the company you’re interested in and search the site for information associated with the third-party information you found.
If you can’t find the information, there’s no harm in emailing or calling the investor relations firm that represents the company and asking the person on the other end of the line to verify the information for you. The key here is to make sure that you never blindly make an investment based on third-party information. Always remember that well-researched, educated investments tend to be the most successful ones.
What to Do If You Identify a Pump-and-Dump Scheme
If you’ve found a pump-and-dump scheme in action, there are a few actions that you should take to protect yourself and others in the investing community. Here are the steps you should take if you suspect a pump-and-dump scheme is taking place.
1. Avoid Investing
Pump-and-dump schemes often lead to dramatic gains, if only temporarily. Even knowing that there’s a fraudster holding the puppet strings, it may be difficult to block out the temptation associated with these dramatic gains. After all, the fear of missing out (FOMO) is a very real emotion that often takes hold.
You might be tempted to jump into the stock believing it’s going to skyrocket before it plummets, and try to get out before the other shoe drops. However, if you are aware that a pump-and-dump scheme is taking place, the risk is far too high to consider an investment for any period of time. In other words, when you see a pump-and-dump, it’s time to turn and run.
2. Gather All Evidence of the Pump-and-Dump Scheme
Avoiding an investment in a pump-and-dump scheme will protect you. However, the best investors not only strive to grow their own wealth, but they also have a desire to help others in the investing community to achieve the same thing.
The remaining steps are all about protecting others from fraudsters and being a valuable, respected member of the investing community.
Start by researching the fraudulent opportunity and taking notes on everything that seems to point to a pump-and-dump scheme. For example, write down any publicly disseminated information that cannot be verified by the company, take note of any disclosures that suggest exorbitant advertising fees have been paid by third parties, and track all false and potentially misleading statements.
3. Contact the SEC
Once you have all of the information that suggests a pump-and-dump scheme is taking place, it’s time to take action. To do so, contact the SEC and inform them of your findings. There are a few options when it comes to contacting the SEC:
- Contact the SEC by Phone: (800) 732-0330
- Contact the SEC by Email: Help@SEC.gov
- Contact the SEC Online: Fill out the SEC’s online tips form
Once you contact the SEC, the regulatory authority will investigate your claims. Should the scheme you found be an actual pump-and-dump scheme, the SEC will move forward with actions to stop the fraudsters from being able to act out schemes in the future.
Keep in mind that if your tip leads to fines of more than $1 million, you will be entitled to a Whistleblower’s Award, putting between 10% and 30% of the fines collected directly into your pocket simply for doing the right thing.
4. Share Your Findings to Protect Other Investors
Since the creation of FINRA and the SEC, the market has been a much safer place, but fraud still happens all the time, and regulatory agencies move slowly. By the time these agencies catch up to the con artists behind pump-and-dump schemes, the schemes are generally over and the damage has been done.
But you have the power to protect your fellow investors.
Investors are often active on social media — in particular, on Stocktwits and Twitter. These social networks use the “cash tag” in order to make finding posts about a specific stock easier for investors. For example, if you want to see posts about Apple on either of these social networks, all you need to do is type $AAPL in the search bar.
When you come across what you believe to be a pump-and-dump scheme, share your findings with the investing community to protect others. To do so, use the cash tag on these networks in a post, outlining your findings and providing links to the evidence behind them.
Sure, this will take a few minutes, but the old adage, “do unto others as you would want others to do unto you,” is an important one in all aspects of life, including investing.
It’s nice to think that financial markets are always fair and equitable. Unfortunately, there’s often a stark contrast between nice thoughts and reality. Although the vast majority of investors and other parties that take part in the market are good actors, bad apples do exist.
By taking the time to do your research and verify the information you find, you not only have the ability to protect yourself, but also to protect others, and potentially collect a large reward for doing so.