Few strategies for financial fraud are as broadly familiar as “pump and dump.” Pump-and-dump schemes—in which fraudsters misleadingly tout cheap or “penny” stocks to lure investors, pushing up the price before selling for huge gains and leaving other investors with significant losses—have featured prominently in films such as The Wolf of Wall Street and Boiler Room. They are fairly ubiquitous offscreen, too: at one point, they were estimated to account for 15 percent of all spam email. But though the tactic is well known and the resulting price distortions well documented, little is known about which investors take the bait.

Research by Chicago Booth’s Christian Leuz, Leibniz University of Hanover’s Steffen Meyer, Maximilian Muhn of Humboldt University of Berlin, Harvard’s Eugene Soltes, and Andreas Hackethal of Goethe University Frankfurt examines who invests in these schemes, and how often. Contrary to the popular understanding that people who invest in such schemes are duped into doing so, the research suggests that some investors actually may seek out these scenarios, perhaps viewing them as analogous to lotteries.

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The researchers examined 421 pump-and-dumps between 2002 and 2015 provided by BaFin, a German financial regulator, along with cases they hand collected from searches on German websites and internet forums. They combined data about these schemes with trading records of more than 110,000 investors from a German online bank to see who actually participated. During the sample period, these investors made a total of 29 million trades with an aggregate transaction value of €178 billion.

Of these investors, 6,569 individuals—nearly 6 percent of the sample—collectively made more than 20,000 purchases during the first 60 days of the pump-and-dump schemes that the researchers identified. These individuals invested an average of €6,972 per tout, or about 11.4 percent of their portfolio’s overall value, and sustained an average loss of nearly 30 percent. Compared with a control group of investors who didn’t participate in these schemes, pump-and-dump investors owned more stocks and had a greater share of penny stocks than reputable “blue chip” stocks in their portfolios.

The penny-stock gamblers

Analyzing the characteristics of traders who bought stocks that turned out to be pump-and-dump schemes, the researchers find that many of them have a history of risky bets.

 A pie chart plotting a breakdown of the average portfolio of an investor who bought a pump-and-dump stock, a total of sixty thousand nine hundred eighty-eight euros, including thirty-point-nine percent penny stocks priced below five euros and fourteen-point-four percent blue chips, from the Stoxx Six Hundred or the S and P Five Hundred. And a second pie chart for other investors who were active at the same time, with an average portfolio of seventy-seven thousand nine hundred twenty-two euros, thirteen-point-two percent penny stocks, and thirty-one-point-nine percent blue chips. Next, a bar chart shows that pump-and-dump investors’ average purchase was three thousand eight hundred thirty-seven euros while others’ average was six thousand six hundred thirty four euros. Next a stacked-block chart shows that pum-and-dump investors made sixty-purchases over the previous year, while others made twenty-nine. Next, a stacked bar chart breaks down the types of investors who bought pump-and-dump stocks: twenty-six-point nine percent were conservative traders, twenty-four-point-three were short-term traders, ten-point-nine percent were penny-stock day traders, and six-point-six percent were new traders. And a second stacked bar chart breaks down other investors the same way: fifty-seven-point-nine percent were conservative traders, ten-point-six percent were short-term traders, two-point-two percent were penny stock day traders, and six-point-three percent were new traders.

On average, each scheme reduced investors’ wealth by €800, generating losses of at least €1.2 million for German online investors. The average investor in tout schemes was an older, married male not residing in a big city, who had a high self-assessed risk tolerance, the researchers find. Blue-collar workers, retirees, and the self-employed were also more likely to invest in these schemes. But trading behavior, demonstrated by the composition of investors’ portfolios and their past trading patterns, was a better predictor than demographics of who participated: more than 35 percent of pump-and-dump investors were day-trading in penny stocks or were frequent traders with short-term horizons, taking substantial risks and trading aggressively before they participated in the schemes, the researchers find.

“The frequency with which some investors invest in touts as well as the composition of their portfolios suggests that not all tout investors are gullible or fall prey to pump-and-dump schemes,” the researchers write. The observation that some investors may actively search for pump-and-dump schemes underscores the need for regulators to better understand who actually buys touted stocks when they’re trying to design more-effective investor protections. Many pump-and-dump stocks trade on over-the-counter or alternative markets that are less regulated than the major exchanges.

For some investors, interventions—such as prompts to take more time before making investment decisions and to think about whether funds look suspicious—could decrease the likelihood of participating in pump-and-dump schemes. But the researchers warn that these techniques are less likely to work for the subset of investors who intentionally seek out such schemes for the sheer thrill of it and the possibility of big, quick gains.

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