Know Thy Enemy: Common Stock Market Swindles

Stock market swindles are as old as time itself.  Most of them are based on a general theme.  Today I want to write a post of many of the most common of these swindles.  The more you understand them, the less likely you are to fall prey to them.

This post was inspired by a tv show I recently watched on my business trip plane ride about the Bernie Madoff Ponzi Scheme.  I can strongly recommend the show Madoff In His Own Words if you have the opportunity to see it.  

Thankfully I have never lost any funds via stock market swindles.  Still, I find being educated about their existence important.  Also, the mechanisms of some of them are at least of intellectual interest.  So with that said here we go.

Ponzi Scheme, The Most Infamous Stock Market Swindle

Let’s start with the stock market swindle that inspired this post.  The Ponzi Scheme is named after Charles Ponzi, who used this concept on a massive scale in the US in the 20s. That being said it owes it’s origins to a period at least a hundred years earlier.  

In a Ponzi Scheme, also known as a pyramid scheme, an organization takes in money from investors.  Then they pay those investors a return based on investments from additional investors. This continues on and on until which time as they run out of new investors.  Then as you can imagine, without new investors, they run out of money and collapse.  

Obviously anywhere the next payoff depends on signing up the next person you should be wary. This is part of the reason why most multilevel marketing companies are compared with Ponzi Schemes.

The Madoff Ponzi Scheme

What really made Bernie Madoff’s Ponzi Scheme significant was the scale of the scheme and the length of time it lasted.    Per the documentary, it is basically believed that the Madoff Scheme lasted from the 60s until the 2009 financial crisis brought it crashing down.  Because of the long time period the whose who of the US were caught up in the scheme and lost massive amounts.

The real thing to look for in a Ponzi Scheme is unrealistic returns over a long period of time.  There were a few people that realized something was shady at Madoffs hedge fund before it became public knowledge.     They did this by simply realizing the stock just went straight up.  It never oscillated with the business cycle or really much at all.  It’s an impossibility that any investment will have stable increasing returns with no dips at all over a long period of time.  So, if it sounds too good to be true, it’s a candidate for one of these stock market swindles.

Pump and Dump Stocks, A Penny Stock Swindle

Have you ever gotten an email about a penny stock you’ve never heard of touting it as the next big thing?    This might be the sign of a pump and dump stock market swindle.  A penny stock is a low priced, low capitalization, low trading volume stock.  The general idea is an investor will encourage everyone they can communicate with to buy a stock.  Then when people start buying the stock price this action will create larger than normal purchasing volume.  Due to simple supply and demand rules, the stock price will increase.  As soon as the stock rises from this buy activity the original investor sells his stock, taking advantage of the bump caused by his or her own communication.

The rules around pump and dump are why most analysts writing about individual stocks give a disclaimer about their position in a stock.    Also, there is a lot of Securities Exchange Commission (SEC) monitoring and regulation around penny stocks for this reason.  

Note some investors have also tried this with negative news and short selling.  There were a lot of claims during the 2009 financial crisis that short sellers were acting in this manner in relation to some of the larger financial institutions.     Simply sell something like Bear Sterns short and then tell the world they will collapse… Then profit.  Either positively or negatively pushing your opinion to profit over other people acting on that opinion is immoral and illegal.  In general, I would recommend ever buying a stock based on someone else’s opinion.

Insider Trading Stock Market Swindle

I wrote a whole post on insider trading and my classification as an insider trader for my employer here. In general, the idea is stocks price themselves based on known information about the underlying company.  If someone has access to the information before the general public they can trade ahead of the public thus capturing a larger percentage of the stock move.    There are many regulations around insider trading, I encourage you to read my post on the topic to learn more.

Front Running

Front running is similar in concept to insider trading but less about information and more about trades.  In a stock-broker environment the stock-broker places your orders for stock purchase.  They thus know what you are going to buy.    So if they have a rather large volume order placed with them they can predict what the market will do based on that order.  Brokers buying before the order goes through to capture the resulting stock move is called front running.  Brokers and others are monitored for front running.   

A note, there is a legal version of front running.  When a stock index adjusts everyone knows the funds following those indexes has to buy the stocks.  As such some people will try to front-run that purchase.  However, one could argue there are no gains to be had with the legal version.  Afterall based on the efficient market theory the intent of the funds to purchase these stocks is priced in as soon as the news is distributed.

Accounting Fraud

The first company that comes to mind when I say Accounting Fraud is probably Enron.  In case you are too young or just didn’t pay attention a few decades ago.  Enron was a company that produced and traded energy.  Anyway, they created a labyrinth of company setups and accounting tricks to make themselves look highly profitable.  Meanwhile, they were losing money left and right.

All major public companies are required to have outside audits of their books to ensure they are not using illegal accounting tricks to cover up their true financial situation.  Even in the time of Enron, pre-2001, this was true.  The problem was, at the time these outside audit companies had some severe conflicts of interest.  Some of these conflicts led them to declare Enron’s books clean of accounting tricks, or so the story goes.

Anyway, Enron was a massive company.  When it fell it took out many large investors and left 29,000 employees without jobs.  Just like Madoff, the fall happened almost overnight when the market quickly understood the scope of the maleficence.  

The best thing I’ve seen come out of the investing world due to Enron is the now ubiquitous advice not to hold stock of the company for which you work.  Many of those 29,000 people also had their 401ks invested in Enron.  So when the stock fell they lost their job and their savings.  

The Enactment of Sarbanes Oxley

Anyway also as a result of the Enron debacle the government passed the Sarbanes Oxley rules.   These rules required things like redundant controls, division of duties, independent auditors, and enhanced financial disclosures.  On the flip side, for those younger in the crowd, if you’ve ever wondered why your work large public work-place has so many redundantly bureaucratic policies and procedures, you can probably thank Enron.    Many companies put in place a lot of overhead to get in compliance, some in excess.  

Embezzlement

Finally, we come to simple embezzlement.    Your stockbroker just runs off with your money.    Not as common these days with the rise of the mega brokerages.  Still embezzlement gives a strong recommendation to not invest your money at some fly by night brokerage.

Stock Market Swindles Usually Follow One of the Above Themes

So, there we have it.  A long list of stock market swindles.   In my experience most stock market crimes fall into a variation of one of the above. Now you know what to look for to avoid being taking advantage.   Feel free to throw out any swindles or chicanery I may have missed in the comments below.