We look at how pump and dump works and how investors can avoid such fraud
06-Dec-2022 •Samridh Rela
The Wolf of Wall Street sure kept us entertained for three hours and brought scams like pump and dump into pop culture.
Jordan Belfort, the protagonist of the film The Wolf of Wall Street, robbed investors of nearly $200 million after executing a pump-and-dump scheme with penny stocks. While the exact details of these kinds of scams may vary, it always starts with wolves like Belfort luring investors in with lies and wild speculations.
So in this story, we look at how pump-and-dump schemes are executed and how you, as an investor, can stay away from these wolves.
How pump and dump works
In simple terms, pump and dump refers to when people with an established position in a stock (promotors, operators, stockbrokers, etc.) pump up or boost a stock's price by creating fake hype around the stock and then dump or sell these stocks once the price has increased.
Markets are always forward-looking, meaning that markets value a stock based on how the underlying business may perform in the future. Analysing a business's future prospects is particularly difficult for smaller businesses (small-cap, micro-cap, and penny stocks), as there is not much information available on them.
Perpetrators of pump-and-dump scams (which usually include operators, stockbrokers and promoters who have established positions in a stock) take advantage of this lack of information. They try to scam unsuspecting investors into buying bad businesses by bombarding them with emails and phone calls claiming they have some inside information and have identified the next multibagger. As little information is available on these businesses, investors are often easily duped and invest huge sums of money in these stocks.
These huge investments then balloon the prices, and as soon as the prices are high enough, the frauds initiate a massive sell-off. This plummets the stock prices, investors who get carried away in the lies and hype lose millions overnight, and the frauds fill their coffers.
What can you do as an investor
So does that mean you should only purchase blue chip stocks?
No. While it is true that these frauds usually involve smaller businesses, the underlying problem is falling for the hype.
No matter the size, as an investor, we should always do our due diligence before investing in a business. If you feel you cannot arrive at a conclusion and need more time and information, you should not give in to FOMO (fear of missing out) and wait till you have a clearer picture. Remember, stockbrokers are vested in getting you to transact more, as that is how they make their profits.
The onus is upon us, as investors, to ensure we have all the information we need before investing.
Not everyone has the time
We realise that fundamental analysis of a company requires a lot of time, and not everyone has the luxury of spending hours reading annual reports.
This is where our stock advisory service - Value Research Stock Advisor - comes in.
We have a list of stocks ready for investors to start building their portfolios. We provide in-depth coverage of all the stocks we recommend and never shy away from asking you to sell if we feel the fundamentals of a business are declining. Our motto is simple - find fundamentally strong businesses for our subscribers and give them everything they need to assess these businesses based on their risk appetite and investment goals.