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The Pump-and-Dump Stock Scam, Explained
Investing in the stock market is a risky endeavor. Not only does it come with the inherent risk of investing in stocks and their fluctuating value, but the stock market is also a place where scams can take place, fooling and ripping off the unaware.
One of the most historically popular of these scams is the pump-and-dump strategy. It’s particularly noteworthy because it’s a classic scam that has survived and even thrived in the internet era. Let’s take a closer look.
What is the pump-and-dump stock strategy?
A pump-and-dump happens when someone inflates the price of a particular stock by using overly positive and misleading statements about the company, which causes the price of the stock to go up as more people become interested in buying shares in that company. That’s the “pump” part of it. Then, the pump-and-dumper sells the stock at this artificially inflated price, making a big profit. That’s the “dump” part.
Pump-and-dump scams are illegal. The Securities and Exchange Commission (SEC) takes pump-and-dump schemes very seriously, constantly investigating them and following new versions of the scam. It is considered a form of fraud and is prosecuted very intensely.
Why does anyone buy into pump-and-dump schemes? Usually, pump-and-dump scammers choose to hype up the stocks of very small companies (or other obscure investments, like cryptocurrency). This is because the amount of actual reliable information about these obscure companies is limited, so they’re able to fill that void with overly positive and misleading statements so that it appears everything is rosy. This is easy to do in the age of the internet, where people can use spam, fake websites, social media and other tools to spread false information.
How the pump-and-dump strategy works
Here’s an example of how a pump-and-dump scheme might work.
Let’s say Tony owns 100,000 shares of an obscure company that’s worth $1 a share and isn’t changing much in value. This company isn’t well known at all — no one is really buying or selling shares in it because few people have even heard of it. There aren’t many Google results about the company other than really dry stock information pages.
Tony sets up a few fake websites talking about how great this company is, and opens up a few social media accounts to talk it up, too. He buys a big list of email addresses and sends messages about the company to all of them, too.
Most people ignore it, but a few read the emails or find the social media accounts and get curious. They do Google searches and find glowing information about the company and invest. These new buyers push the price of Tony’s stock up to $5 a share.
At that point, Tony sells all of his shares — now worth $500,000 — turning a $400,000 profit, and walks away from it, with all of the people who bought shares at $5 now holding overpriced shares in that obscure company.
Real-life examples of pump-and-dump scams
Perhaps the most well-known example of a pump-and-dump scam was told in the movie (and book) The Wolf of Wall Street. It tells the real-life story of Jordan Belfort and his brokerage Stratton Oakmont, which engaged in repeated pump-and-dump schemes.
Another well-known real-life example of pump-and-dump happened with Enron in 2001, as reported by the New York Times. Insiders made enormously misleading positive statements about the company to artificially inflate the stock price, including using accounting tricks on Enron’s financial filings, while quietly selling off their shares at the inflated price.
However, most pump-and-dump schemes happen quietly. They affect a small, obscure company, with just a scammer or two ripping off a handful of overeager investors. Most of them end with a quiet investigation that most of us never hear about.
Avoiding the pump-and-dump stock scam
Avoiding this scam is actually quite easy. Simply don’t invest in anything that you don’t know very well. If you have never heard of a company until recently, don’t buy stock in that company, even if it seems like the deal of a lifetime.
Save your investment dollars for smarter investments, like index funds or, if you wish, stocks in individual, reputable companies that you know well.
As a more general rule, simply don’t believe information that doesn’t come from at least one highly reputable source, or, ideally, several reputable sources. If you learn something new, don’t take action on it (or even wholly believe it) until you’ve verified that information in several places with a good reputation for reliable information. Remember, no information source is perfect, but reliable ones have a good, long track record of being right most of the time, and if several of them agree, you’re in good shape.
How to safely invest your money
With scams like the pump-and-dump running around, what can an individual investor do to invest their money safely? There are three key elements to safe, smart investing:
- Become knowledgeable about the stock market. As noted earlier, the most powerful tool an investor has is knowledge and understanding. Start from the basics, like knowing what a stock actually is, and build from there so that you know all of the basics of stock investing. You should also take particular care when it comes to taking your first steps into stock investing.
- Stick with reputable investment firms. Keep your investments with large, reputable firms that don’t engage in the business of pushing you into particular investments. If you’re choosing an investment firm or a brokerage to use, look at a wide array of recommendations from a variety of sources before settling on an investment firm that’s right for you.
- Don’t follow pop culture trends, follow business trends. It can be tempting to simply invest in what you’ve heard of or what’s popular at the moment, but the truth is that business success and pop culture success are often not in alignment.
Instead, you should learn how to read the business news and information and what that means for your investments. Take the time to read some great investment books and learn enough about economics to understand things like how unemployment affects the price of stocks. This, of course, ties back into the point about knowledge, which is the real key to investment success.