Who Falls Prey to the Wolf of Wall Street?

Seniors [are] particularly vulnerable to investment scams” read one headline. “We are taking further steps to find and eliminate from our system pump-and-dump scammers, those who prey on retirees,” noted Jay Clayton, chairman of the Securities and Exchange Commission. The news media, movies like “The Wolf of Wall Street,” and even regulators have long portrayed the elderly and other vulnerable people as the most frequent victims of these fraudulent schemes. Yet, do we actually know who invests in pump-and-dump scams? It is a critical question, because designing effective investor protection requires understanding who invests and why.

In our paper, available here, we shed light on investor participation in pump-and-dump schemes. Our analysis combines a large set of frauds provided to us by the German supervisory authority, BaFin, along with trading records for over 110,000 individual investors from a major German bank. The confidential trading records not only allow us to assess the returns or losses of individual investors that participate in pump-and-dump schemes, but also contain information about the characteristics of participating investors, their trading behavior, and their portfolios. Using this data, we can examine some of the common perceptions—or, as we find, misperceptions—about who invests in pump-and-dump schemes.

Frequency of investment. We find that participation in pump-and-dump schemes is quite common. Nearly 6 percent of the investors in our sample invest in at least one pump-and-dump scheme during our sample period of 2002-2015. Moreover, in any given year, there was a 2 percent chance that an investor in the sample would take a position in at least one such scheme. This amounts to a lot of trading in such frauds: We document 6,569 individuals making over 20,000 purchases during the first 60 days of 421 pump-and-dump schemes.

Characteristics of investors in scams. When compared with other equity investors, we find that investors in fraudulent schemes tend to be older, less wealthy, and, by their own admission, more tolerant of risky investments. They also tend to be male and to live outside of cities. However, personal characteristics are less accurate than portfolio composition and past trading behavior as predictors of who will likely invest in a scam. Specifically, we find that such investors hold substantially more shares of risky penny stocks, fewer shares of blue chip stocks, and more individual stocks overall.

Size of pump-and-dump investments and investor losses. Investments in pump-and-dumps tend to be considerable and comparable in size to other equity investments made by these investors. Investors put on average close to €7,000 into a touted stock, which is sizeable relative to their average portfolio value (11.4 percent of its total value). By comparison, the average investment outside pump-and-dump schemes for these investors is around €6,000. As would be expected, pump-and-dump investments on average produce considerable losses, with the average return to a pump-and-dump scheme being -28 percent. Aggregating losses across investors in our sample, we estimate that the average fraudulent investment scheme generates losses in excess of 1 million euros for German online investors alone. This illustrates that pump-and-dump schemes are not small financial crimes.

Repeat pump-and-dump investors. Given the significant negative returns, it is perhaps surprising that we find a considerable number of individuals investing in more than one pump-and-dump scheme (36 percent of our sample). In fact, roughly 11 percent of such investors place money in four or more schemes during the sample period. These investors do less poorly in their initial investments, but they still lose on average 24 percent across all their investments in pump and dump schemes. These investors have larger-than-average investments and a large fraction of penny stocks in their portfolios.

The frequency with which some investors put money in these schemes  as well as the composition of their portfolios suggest that not all of them are gullible or fall prey to pump-and-dump schemes. Instead, it appears that some investors seek out pump-and-dump schemes and view them as gambles or lotteries.

Types of investors in pump-and-dump schemes. To assess the characteristics of traders in touted stocks and better understand the vulnerability of retail investors to fraudulent schemes, we group investors based on their past trading behavior in other stocks. By relying on that behavior, we can assess how the likelihood of participating in pump-and-dump schemes varies across types of investors. We find that more than 35 percent of investors in such schemes have been day-trading in penny stocks or are frequent traders with short investment horizons. These investors appear to be willing to take substantial risks and trade aggressively also in other stocks. We find that these investor types are more likely to invest in pump-and-dump schemes, place larger bets, and have relatively better returns.

Broader ramifications on portfolio and later trading behavior. Finally, we find that investors’ subsequent investment behavior is associated with the prior performance of pump-and-dumps. Specifically, investors with relatively poor returns from such schemes in the past are less inclined to invest in another one and may stop trading at all. Those with more positive returns invest more quickly in the next one and stay in longer (which tends to hurt performance and perhaps indicates overconfidence). Moreover, we find that, even three years after losing money in a pump-and-dump campaign, investors still make fewer equity trades than they did before the investment. Thus, we find some evidence that participation in a pump and-dump campaign can have a lasting effect on the behavior of some investors.

Overall, our analysis contributes to a more nuanced understanding of market manipulation and investor protection. Our findings highlight the significant heterogeneity among investors participating in deceptive market manipulation like pump-and-dump schemes. There appear to be several types of individuals, including investors who trade infrequently and perhaps are more vulnerable. But there is also a substantial fraction of investors who trade frequently and often day-trade in penny stocks. These investors are more likely to gamble with touted stocks, rather than being fooled by the schemes. Importantly, we find that demographics provide only limited insights into who participates in pump-and-dump schemes. Instead, portfolio characteristics and past trading behavior, which are probably indicative of the trading motives, play a much larger role.

In sum, investments of the type peddled in “The Wolf of Wall Street” still cause considerable damage to portfolios. But our investigation indicates that the common perceptions of who, on average, is most adversely affected may need to be reconsidered. The results also suggest that a more nuanced approach to protecting investors in microcap stocks might be worth considering.

This post comes to us from Professor Christian Leuz at the University of Chicago’s Booth School of Business, Professor Steffen Meyer at Leibniz Universität Hannover, Maximilian Muhn at Humboldt University of Berlin, Professor Eugene F. Soltes at Harvard Business School, and Professor Andreas Hackethal at Goethe University Frankfurt’s Faculty of Economics and Business Administration. It is based on their recent paper, “Who Falls Prey to the Wolf of Wall Street? Investor Participation in Market Manipulation,” available here.

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