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Updated on Wednesday, February 13, 2019
Stock scams are a common way to separate stock market investors from their money. They often start simply — maybe offered by a friend of a friend. Many times they include promises of potential profit that are too good to turn down. If these scams have anything in common, it is that they usually end badly, with the victim owning stock that has little or no value and feeling cheated. Chances are they have been.
What a stock scam looks like
How can investors learn to recognize a potential stock scam? Perhaps the best advice is to educate yourself. Understand the different types of scams you might fall victim to and how to steer away from them. And don’t be afraid to ask questions! Asking the right questions can help you avoid costly mistakes.
Here are some common types of stock market scams that all investors should be on the lookout for:
Pump and dump
We know how easy it is to spread false information about virtually anything, especially investments. Many fraudsters do that in a scheme known as pump and dump. It starts with promoting a particular stock by any means possible — the company’s website, online investment newsletters, chat rooms, email, text messages, phone calls and fax — to potential investors. All methods typically talk about how well the company is doing and may even tie into a real event such as a new product or higher earnings, but add false information to make the stock sound even better.
This campaign stimulates interest from investors who buy the stock and drive up the price. Then the people who started it all sell their shares and stop promoting the stock, driving the price back down again. If new investors want to sell, they generally have to do so at a much lower price.
These frauds are named after Charles Ponzi, a 1920s con man. In a Ponzi operation, someone at the center of the scheme collects money from new investors. Instead of investing it, he or she uses it to pay inflated returns to earlier investors. The scheme can go on for quite a while, usually until the person at the center is no longer able to attract new investors or too many people want to liquidate their investment.
Despite their nearly 100 year history, Ponzi schemes continue to this day. Back in 2009, Bernie Madoff pleaded guilty to 11 felonies, confirming that he had defrauded his clients of nearly $65 billion over 20 years, making it the largest Ponzi scheme in history.
Pyramid schemes work much like Ponzi schemes, except existing investors recruit new people into the scheme. In many pyramid schemes, “investors” make more from recruiting new members than they do for investing. As with a Ponzi scheme, their investment is used to pay returns to earlier investors until the entire scheme collapses, with most investors losing money.
A well-known pyramid scheme from the 1980s involved United Sciences of America which sold nutritional supplements through distributors. The scheme preyed on common health fears and promised their products would protect people. The scheme ended in 1987 when three states told the company to change its advertising claims.
This type of fraud targets members of a particular immigrant, ethnic or minority group, church or religious organization, the elderly, members of the military or similar groups of people with a common background.
The person offering the deal may claim to be a member of the very same group he or she is targeting. Investors often let their guard down when they feel someone with a shared bond such as military service is offering them a great deal and make that deal without ensuring the investment is legitimate or that the return claims are realistic. Affinity fraud can involve virtually any investment, including stock.
Advance fee fraud
This fraud is fairly simple. You own an investment that has been performing poorly and you want to sell it. Someone contacts you with an offer to buy your investment at an excellent price. All you have to do is send them an advance fee for the privilege of liquidating your investment. You send the money and never hear from them again. And nobody buys your shares.
Internet and social media fraud
This type of fraud involves spreading false or misleading “good news” about a particular stock using the tools available online such as websites, social media posts, chat rooms, text messages and emails. The goal is to increase the price of the stock so the originator of the disinformation campaign can sell their shares at a high price. Once that happens and the campaign stops, the stock price is likely to fall (and may fall fast).
Microcap companies are those with few assets and low-priced shares that trade at low volumes. They are frequent targets for fraudsters looking for companies to use for pump and dump and other frauds. In microcap fraud, those perpetrating the fraud buy shares at a low price. Then they use a wide variety of means (as mentioned above) to raise interest in the stock and increase the price. Then they sell. When they stop promoting the stock, the price drops.
The Securities and Exchange Commission (SEC) frequently suspends trading in these stocks before they can become fraud targets.
Pre-IPO investment scam
Many investors want to get in on the ground floor of any potentially lucrative investment opportunity, especially an initial public offering (IPO) of a stock. This type of scam offers the chance to buy so-called hot stocks ahead of the IPO. While there are legitimate offers to buy shares before an IPO, unregistered offerings may violate federal securities laws unless they meet a so-called registration exemption by only being offered to investors who meet income and net worth requirements.
Given the interest in owning IPO shares, this is a good time to ask “why me” in terms of why are they offering you this opportunity instead of literally thousands of other investors.
These scams originate in foreign countries and target U.S. investors. They can involve any of the scams described above. Many fraudsters use Regulation S, which says U.S. companies don’t have to register securities with the SEC if they are sold exclusively outside the country to offshore or foreign investors. Some fraudsters violate this rule by reselling Regulation S stocks to U.S. investors in violation of the law. Since they are outside the country, U.S. authorities have difficulty in prosecuting them.
Five tips to avoid potential stock scams
Although the internet has made it easier than ever to spread stock scams around the world, it has also made it easier for the average investor to research a potential stock deal to make sure it is legitimate.
Here are some tips investors can follow to keep their money safe.
1. Educate yourself
The more you know about stock scams, the easier it will be to spot one that finds its way to your inbox. Read articles, do research on the Internet, talk to other investors. Keep up to date on the latest scams.
2. Ask yourself, why me?
If someone offers you an investment that sounds too good to be true, ask yourself why, among thousands of investors who might be interested, did someone offer you the chance to invest? Many times, the answer might be that they thought you would be easy to scam. If so, walk away.
3. Investigate investments that don’t come through traditional channels
If a broker from a reputable firm you have worked with for many years calls to offer you a great deal, chances are it is legitimate. But if you get a call from someone you have never met, do some research before investing. Google the investment. Ask the caller if you can talk to other investors. Check with organizations such as FINRA and the SEC to make sure there are no complaints against the people sponsoring the investment. The more questions you ask, the better the chance you will find a legitimate investment.
4. Be cautious about offers of high returns with low risk
If the investment sounds too good to be true, chances are it is. While there are still some undiscovered gems out there, the chances of someone you don’t know contacting you to offer one are slim. Check out every investment carefully.
5. Take your time
Don’t be pressured into investing in anything immediately. Chances are if someone wants you to invest quickly, there are some details they don’t want you to know about. Take as much time as you need to research a potential investment before you decide to invest. Ask questions and get answers.
No matter what you are buying, it helps to have a little skepticism before you make the purchase. When you buy a quart of milk, you always check the expiration date first. Investors should apply the same caution to stock purchases. Understand who is offering the investment, what promises they are making and what the consequences are of losing everything. Then, decide if you will invest or wait for the next deal. Chances are, another one will come along soon.