It’s a dangerous place out there – and the stock market is no safe place. Throughout history there’ve been con men, but recognizing the cons being played in the stock market isn’t always as simple as looking out for the guys running a three-card Monte setup. There are sooOOooooOo0 many types of stock market scams. There are scams on scams on scams – let’s explore three.
Scam #1: The Pump and Dump
Pump and dump is one of the most well known Wall Street scams where investors (i.e. swindlers) artificially cause the price of a stock to rise. They “pump” up the stock, and when the price reaches astronomical levels…they “dump” it – netting a huge profit on the price differential. In a pump and dump scheme, charlatans tend to first build up a position in a stock. A lot of times the target will be an unassuming penny stock.
While there is no universal definition of what a penny stock is, they are inexpensive stocks, generally trading below $5 a share. Penny stocks are typically characterized by having poor liquidity in trading. This is dangerous because when con artists succeed in pumping their prices, it can be super difficult for investors to get rid of their shares once people realize what’s happening and the panic sets in.
For example, a group of investors (i.e. swindlers) bought tens of millions of shares in My Vintage Baby – a children’s clothing company – in the middle of 2007, at cut-rate prices (pennies per share). These pump and dump artists then spread the word far and wide about their amazing investment. According to the SEC, with the help of Summit Advisory Group in Dallas three stock promoters were able to conduct a nationwide marketing campaign, using email, numerous ad campaigns and misleading promotional materials to whip up the stock price to the point where they were able to make more than $20 million by dumping their shares into the artificially inflated market. At its peak, these hucksters were able to push the price of My Vintage Baby to $2.88. There are so many other instances of pump and dump schemes taking place.
Scam #2: The Ponzi Scheme
Bernie Madoff is probably the most well-known proponent of the Ponzi scheme these days, but this kind of fraud actually goes back to the 19th century. It began when William Miller opened up the Franklin Syndicate and defrauded investors out of $1 million. The scam is named after Charles Ponzi who abused it back in the 20s. The idea behind this scheme is to continually attract investors to an organization, using the money that new investors pay into the venture to pay the people who came in before them. Once investment slows down the fraud collapses.
Actually, what Madoff did was a classic Ponzi scheme. He lured in investors with promises of unusually high returns. He would then deposit his investors’ money into a Chase bank account (instead of investing it on their behalf). If a client wanted their money, he’d pay them using money from either their account or that of another client. The people who worked for Madoff would create fake trading reports to match the investment return that Madoff ordered. Kind of like a double cheeseburger from McDonalds, for each client. I’ll take a 10% return on Johnson, hold the dividends please! It turned out that Madoff hadn’t traded a thing since the early 90s and all the returns were fake.
The fraud started to come apart at the seams in 2008. The recession hit and investors saw the world crumbling around them. They decided it was time to take out their money and a total of $7 billion was collectively requested. Madoff didn’t have that kind of money sitting around in Chase bank accounts. In fact…Madoff recalls that he might only had somewhere from $200 to $300 million available to pay out to his investors. It’s a bit like running a bank – in that the bank collects money from clients – but doesn’t hold all of it at the same time. If everyone wants to withdraw their funds at the same time, there can be trouble. Not everyone will be able to get paid. This is known as a bank run and can cause banks and financial institutions to go bust. Madoff tried to stem the tide by attracting more investors – but it was too little too late.
Scam #3: Front Running
This type of security fraud occurs when a broker takes advantage of information he has from his customers to make trades on his own account. Imagine you are a stockbroker with hundreds of clients and you start seeing orders to buy large amounts of Apple stock. If there are tens of orders buying a million shares of the company, you know that this is definitely going to move the price. If you buy a couple hundred Apple shares before executing the orders, you’ll get in at the price trough. Execute those trades, watch the share price rise and sell off your shares to make a tidy profit. Easy game, right?
Unsurprisingly, this type of practice is super illegal. It’s crazy which companies have been implicated in engaging in this sort of behaviour, including but not limited to financial stalwarts such as Goldman Sachs, Morgan Stanley, Bank of America. The worst bit about this is that big firms have high frequency trading programs that allow them to buy shares mere milliseconds before their customers’ orders go in. It enables them to get in ahead and skim a few cents here and there. Those cents add up.
Ugh. So What’s a Guy to Do?
Well, not much. Seriously, there’s really not much you can do about a lot of these scams. Sometimes it can feel like the game is rigged. The best you can do is stay on the lookout for anything that seems too good to be true.
To learn more about how to not lose money, ch-ch-check us out at Wall Street Survivor :)