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Updated on Thursday, December 17, 2020
Stock scams are a common way to separate stock market investors from their money. They often start simply and many times they include promises of potential profit that are too good to turn down.
But if these scams have anything in common, it’s that they usually end badly: The victim is left owning stock that has little or no value, with the feeling they’ve been cheated. Here are the red flags to look out for so you don’t fall victim yourself — and the steps to take if you suspect you have.
- What a stock market scam looks like
- How to avoid potential stock scams
- What to do if you suspect stock fraud
What a stock market 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 and doing your research 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 to potential investors by any means possible — the company’s website, online investment newsletters, chat rooms, email, text messages, phone calls and fax. 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, they use 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; it 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 they’re targeting. Investors often let their guard down when they feel someone with a shared bond 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’s 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 stock 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).
Penny stock scams/microcap fraud
Microcap companies are those with few assets and low-priced shares that trade at low volumes, also known as penny stocks. They are frequent targets for fraudsters looking for companies to use for pump and dump and other frauds. In penny stock scams, those perpetrating the fraud buy shares at a low price. 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 they’re offering you this opportunity, as opposed to 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. And since they are outside the country, U.S. authorities have difficulty in prosecuting them.
How to avoid potential stock scams
Although the internet has made it easier than ever to spread stock scams around the world, it’s 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. Here are some red flags to keep an eye out for — and run far away from:
- It seems too good to be true. If a deal sounds too good to be true, it probably is. This doesn’t mean that every cheap stock is a bad deal, but it shows why you have to do your research on the stock and the deal you’re about to get into.
- There’s unverifiable information. If a broker or fellow investor provides you with information regarding a stock trade — the stock price, the company or their own credentials, for example — and you can’t verify those “facts” with another source, there’s a strong likelihood it’s fraudulent. Brokers must be registered with the SEC and the Securities Investor Protection Corporation (SIPC). The SEC and SIPC websites are also great resources for stock and broker information.
- You’re asked for advance fees. Fraudsters may ask for advance fees for their “services.” Be wary if you didn’t know about the charge beforehand, or if they ask you to pay via unconventional methods (such as cash wire, transfer or Venmo). Only do business on reputable sites and with credentialed individuals and businesses.
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 this chance to invest? Many times, the answer might be that they thought you would be easy to scam.
Go with your gut if something doesn’t feel right — and get out fast.
3. Investigate investments that come through untraditional channels
If a broker from a reputable firm you’ve 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’ve never met, do some research before investing.
Google the investment. Ask the caller if you can talk to other investors. Check with organizations like the Financial Industry Regulatory Authority (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’ll find a legitimate investment.
4. Be cautious about offers of high returns with low risk
When it comes to investing, there’s always going to be some risk and typically, high returns come from high risk. While there are still some undiscovered gems out there, it’s unlikely the promise of a novelty stock with high returns but low risk will pan out well. The chances of coming across a gem like this are even lower if someone you don’t know is contacting you with an offer. Check out every investment opportunity 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.
What to do if you suspect stock fraud
If you suspect a stock scam or have already fallen victim to one, you must act quickly. It isn’t guaranteed that you’ll recover any lost money or the fraudsters will get caught, but your odds are much better the faster you notify the authorities.
Here are the steps you should take:
Contact your bank. If you’ve already made a payment to a bad actor, tell your bank about it as soon as you can. Otherwise, you may miss the short window of time within which you can get your money back. Note this applies to electronic payments; your bank’s unlikely to be able to help you if you handed over cash.
Flag the scam for investment regulators. Not only may this help you, but it may also stop the scammers and prevent others from falling victim. These are the appropriate agencies to contact:
Notify local law enforcement. Bringing law enforcement into the picture may result in catching the scammers. Filing a claim with law enforcement also helps create a paper trail, which is useful in such situations.
Consider enlisting an investment fraud lawyer. An investment fraud lawyer can help advise you on how to best handle the situation — especially if the legal aspect escalates. However, don’t forget that lawyers can cost a pretty penny, and if you’ve already lost sums to the fraudster, hiring an expensive lawyer may not be your best financial course of action.