Many investors think they can outsmart the wolves of Wall Street, betting they can outmaneuver “pump-and-dump” schemes and bring home a windfall.
Rather than being lured into fraudulent trades, some investors seek out such schemes, according to research by Harvard Business School Professor Eugene Soltes and his coauthors. Their analysis of 470 pump-and-dump schemes finds that participants lose one-third of their investment, on average.
“There’s a subset of people who are actually looking for pump-and-dumps,” says Soltes, the McLean Family Professor of Business Administration. “That was fairly provocative and surprising.”
Pump-and-dumps conjure images of inexperienced investors duped out of their life savings. On the contrary, Soltes’ research shows that many speculative traders seek out shady penny stocks—with some viewing warnings as buy signals—in search of a quick buck in a hot market.
“These investors appear to be quite similar to the risk-seeking traders that were fueling the recent surge in trading in speculative meme stocks,” write the authors of “Who Falls Prey to the Wolf of Wall Street Investor Participation in Market Manipulation,” published in the journal Management Science in November.
Soltes cowrote the paper with Christian Leuz and Maximilian Muhn of the University of Chicago’s Booth School of Business, Steffen Meyer of Denmark’s Aarhus University, and Andreas Hackethal of Goethe University in Frankfurt.
A tale as old as the Great Depression
Pump-and-dump promoters buy large amounts of inexpensive and often illiquid shares, and then distribute false information about the company unrelated to their fundamentals. The “tout”—often through email, newsletters, and online forums—sparks a buying spree.
However, because these stocks often have a limited number of shares to trade, prices spike. At some point, the promoters sell, reaping big profits, and other investors are left with losses.
The strategy, immortalized in films such as “The Wolf of Wall Street,” has been around since 1929, when such a scam helped set off the market crash that would spark the Great Depression.
Who are ‘tout’ investors?
Soltes and fellow researchers examined 470 allegedly illegal “tout” campaigns in Germany from 2002 to 2015, including those identified by the German Federal Financial Supervisory Authority (Bafin). They also analyzed 178 billion euros ($208 billion) of stock trades by 113,000 retail investors during that time as well as their demographics, data provided by a major German bank.
Among them, 8,600—7.6% of the sample—participated in at least one tout. About 15% of those people invested in four or more touts. The data suggest that pump-and-dump investors:
Understand the risks. Almost 20% of the sample were day traders or short-term investors, compared with 5% of the control group. It’s unlikely that they were deceived, the authors write.
Trade often, with more portfolio volatility. They’re more likely to hold penny stocks than blue-chip shares.
Lose 31% on touts, on average. Losses among “multitout” investors were cumulative, even among those who thought they could time an exit to reap a profit. However, some tout investors—particularly those who get in early—can gain.
Tend to abandon the stock market after a tout. Rather than reallocate to safer stocks and funds, tout investors are 20% more likely to close their accounts within three years.
“These investors are likely overconfident and perhaps overestimate their stock picking and market timing abilities,” the authors write.
What can regulators do?
The researchers estimate that the average tout generates 1.45 million euros ($1.75 million) in losses in Germany, topping most financial fraud cases prosecuted in the US. And worse, they hurt investor confidence in financial markets.
While it makes sense that regulators would issue warnings to help investors avoid touts, the authors found that the approach can backfire for some.
“We originally thought that if you were able to identify pump-and-dump stocks and put a warning label effectively on them, it might dissuade people,” Soltes says. “However, there's actually an entire other group that may drive into these stocks with those warnings, which is exactly what we now see with some of the meme and crypto trades.”
Based on the findings, regulators might gain more traction by:
Adding disclosure rules for penny stocks
Regulators could help safeguard against pump-and-dump schemes and shore up what Soltes calls the “integrity of investing” by requiring companies traded outside exchanges to disclose audited financial statements.
Focusing on behavior instead of demographics
The researchers found that age, income, and other personal characteristics were less likely to predict tout participation than portfolio composition and trading behavior. Regulators could use trade data to develop more targeted interventions.
Considering how touts spread today
Digital channels such as email, newsletters, and social media have made pump-and-dump schemes cheaper and easier to execute. Stock spam that seems more polished and credible is more likely to lure investors.
If companies are traded because of “some non-informational event on Reddit, that undermines the purpose of capital markets—to raise capital, spur innovation, and generate sustainable long-term growth for stakeholders,” Soltes says.
Illustration created by Ariana Cohen-Halberstam with asset from Adobe Stock/Maximusdn.
