Common Stock Market Scams

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.

Ponzi scheme

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 scheme

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.

Affinity fraud

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.

Offshore scam

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.