Avoiding scams and jail
Lesson in Course: Investing basics (beginner, 7min)
We'll come across advertisements for easy profits or to be able to buy proprietary investing ideas. Are any of them legit?
What it's about: Despite the regulation in the financial industry, there are still traps for unsuspecting investors.
Why it's important: Falling for shortcuts and schemes is a quick way to lose money.
Key takeaway: Be patient. Investing takes time and effort. Don't get suckered into "fast, easy, or guaranteed" profits.
When it comes to investing, anything guaranteed or easy is almost always a scam. Our job is to always fact-check and protect our hard-earned money.
Investing takes time and effort
One of the fundamental principles of investing is that time has value.
Shortcut to learning
Someone is offering us a course that teaches a proprietary investing strategy, one that makes incredible profits, but only if we pay them money upfront. Why are they sharing a very lucrative investing idea with us instead of pocketing it themselves? It's likely because the strategy is not that lucrative — what is lucrative is the fee we are paying.
Speculating
Quick profits are hard to repeat. It doesn't require much effort or time to decide to bet $500 on red in a roulette game. Speculating is gambling, and if we are unwilling to put in the time, we will end up "playing the stock market game." It's easy to double up in roulette, but the casino is for-profit, and the house always wins. A good question to ask whenever we make an investment decision is: are we the house, or are we the player?
Schemes
As emerging investors, we should be aware of and guard ourselves against these four common schemes.
Pump and dump
A pump and dump scheme is the same as a pyramid scheme.
The schemer buys an asset early and then spreads false optimism to create a bubble (the pump) artificially. As speculators buy in and the price jumps, the schemer sells the asset at a profit before the bubble pops (the dump).
Insider trading
Martha Stewart went to jail for insider trading when she sold stock based on non-public information.
If an employee who works for TESLA ends up telling us that their sales have doubled this week, and we act on that information to buy shares before this news becomes public news, we are partaking in insider trading. Insider trading is illegal and will result in fines and jail time.
Front running
Front running is a more sophisticated version of insider trading. Once a trader learns of a big transaction that will significantly move the stock price, the front-runner place favorable trades in their personal accounts to execute right before the big trade.
When Warren Buffet decided to sell $4 billion worth of airline stocks, a front-runner would sell his airline stocks before Buffet's order is processed. Front running lets him sell his shares at a higher price before the $4 billion sell tanks the share price.
Spoofing
In high-frequency trading, spoofing occurs when a trader spams trade and cancellation orders. The rapid entry of trades creates an artificial price that could incite other investors to buy or sell.
Sometimes spoofing can be done on relatively illiquid options making a wide bid-ask spread.
Actionable ideas
If it sounds too good to be true, it probably is. Scammers use false promises to target people.
It doesn't take a finance degree to be a successful investor; however, it does take time. Time to gain an understanding of the markets and time to let our investments grow. Shortcuts and scams are often dangerous ways to lose money.
Supplementary Materials
Glossary
Similar to a pyramid scheme, the schemer buys an asset early and then spreads false optimism to create an artificial bubble (the pump). As speculators buy in and the price jumps higher, the schemer sells the asset at a profit before the bubble pops (the dump).
Trading a public company's stock based on nonpublic material information, consequences potentially include both fines and jail time.
A more sophisticated version of insider trading. Traders front-run orders by placing a buy order in their account when they hear about a massive pending trade that will move the market.
In high-frequency trading, spoofing occurs when a trader spams trade and cancellation orders. The rapid entry of trades creates an artificial price that could incite other investors to buy or sell. Sometimes spoofing can be done on relatively illiquid options making a wide bid-ask spread.