People invest in stock scams even when they know they are scams

Not usually the sign of a trustworthy investment advisor.
Not usually the sign of a trustworthy investment advisor.
Image: Reuters/Andrew Innerarity
We may earn a commission from links on this page.

Why do people buy a stock even when they know there’s a good chance its price is manipulated? Because they want to get rich, whatever the risks. That’s one takeaway of new research by a group of economists studying penny stocks that were heavily touted through suspect email campaigns. It may also explain why people pile into other kinds of risky assets—like initial coin offerings—despite warnings from financial experts.

Some investors actually seek out “pump and dump” ploys in the penny-stock market in search of lottery-like returns, according to research on German stocks by Christian Leuz of the University of Chicago’s Booth School of Business and four other economists. Such schemes typically entail a group of investors quietly buying up a small, thinly traded stock, and then pumping prices higher via heavy promotion through emails. After convincing others to buy, the group dumps the stock en masse and leaves duped investors holding securities that are close to worthless. The practice made a fortune for Jordan Belfort, of The Wolf of Wall Street fame, before he went to prison.

Nearly 6% of active investors end up in these schemes and lose an average of 30% of their investments, according to the economists’ examination of 421 pump-and-dumps between 2002 and 2015, based on trading records for more than 110,000 individual investors in Germany. Some investors go back for more: about 11% of them put money into four or more stocks that were heavily touted in an email (or phone) campaign. They lost an average 24%.

The people behind pump-and-dump shenanigans can make fast money, until they get caught: In the US, a Bugatti-driving promoter allegedly drove up the value of a prescription-drug distributor by more than $700 million within two months, according to a Bloomberg report. Shares collapsed when the mass email campaign—called AwesomePennyStocks—ended.

It’s hard to feel sorry for investors who know a stock is being gamed and buy it anyway, but there are also plenty of people who simply get fooled. The economists found that people who lost money on a pump-and-dump campaign traded less frequently three years later. That suggests scams can have a long-lasting affect, denting confidence in markets for years.

This is useful to think about as bitcoin climbs ever higher, despite warnings from people like Nobel Prize-winning economists Robert Shiller and Joseph Stiglitz, who says it has many characteristics of a dangerous bubble. Regulators have also warned investors about initial coin offerings, a freewheeling fundraising method that blends aspects of crowdfunding and cryptocurrencies.

And yet, money continues to pour into bitcoin and ICOs. The evidence from the penny-stock market suggests some people probably think they’re smart enough to get out before a crash, while others will be genuinely surprised if there’s a collapse. For all involved, confidence and trust in these markets may suffer for a long time.