FOOL ON THE HILL: An Investment Opinion
Why Are Investors So Gullible?

In another chapter in an increasingly common story, the SEC has charged 33 individuals and companies with manipulating stock prices for gain by spreading falsehoods about the companies involved. This was not the first Internet-based stock scam, and it doesn't promise to be the last, either. Bill Mann and Jay Perlman reprise some common-sense advice for investors hoping to limit the chance of being in the sites of a scam artist, including such simple methods as remaining skeptical about information that comes from an unknown source and staying away from penny stocks.

By Bill Mann (TMF Otter) & Jay Perlman
September 8, 2000

Just because all of the punctuation is in the right place on an analyst filing doesn't make the author an expert.

Many investors are finding out the hard way that they can't believe everything they read. Often, particularly on thinly traded penny stock companies, there just isn't a countermanding opinion to these breathless "analyses" put up by some anonymous denizen of cyberspace. And yesterday, the Securities and Exchange Commission (SEC) jumped on 33 people who spread false information on the Internet, profiting upon the gullibility of others.

The perpetrators in these cases pumped up the collective stock prices of some 70 penny stock companies by $1.7 billion. In a few cases, the companies themselves were complicit, but in general the "pump and dump" was done by promoters who used the power of the Internet to spread their particular form of fertilizer. And while we believe the SEC should be commended for its aggressiveness in bringing cheaters to heel, we're certain that the majority of those who have been taken in a pump and dump don't even realize it, and that we've seen only the tip of the iceberg.

The Fool believes that the individual is the best person to manage his or her money, so we do not believe that one must have multiple advanced degrees to become a better-than-average investor. And our discussion boards are a powerful place for these investors to share opinions. There are many outstanding Fool contributors who have no formal securities training. For example, one of our most respected contributors is an opera singer by trade.

Of the alleged perpetrators in the most recent SEC sweep, one was a college student who drives for a car service, another a bus mechanic. Their specific training aside, these men, along with the other 33 companies and individuals, do nothing but weaken the contract that is the U.S. public markets. If upstanding security analysts, journalists, and even discussion board participants have their motivations questioned, it's only because the likes of these who have made people suspicious.

But evidently not suspicious enough. P.T. Barnum's adage of a sucker being born every minute holds ever true in the age of the Internet, where people can wreak havoc with only a computer and a modem. But if the field wasn't fertile, the rats wouldn't forage.

There is a significant difference between the two-way discussions that take place on some boards and the shameless hype that takes place elsewhere. Unfortunately, too many investors are blinded by greed and gullibility to see the difference. The SEC, securities laws, and even the policies of the companies providing these boards are unable to protect investors who take no measures to protect themselves.

Whenever one of these Internet fraud cases hits the news, there are always the gloom and doom naysayers who claim that the Internet is dangerous for investors. Of course, these naysayers include the full-service brokers who like to use these cases as examples of why ordinary investors can't do this on their own.

Sure, the Internet makes fraud easier, cheaper, and more efficient. But the reality of the situation is that the Internet has done more for the ordinary investor than any other financial tool. The Internet provides access to market participants and market information 365/24/7, it gives investors a forum to do their due diligence, and most importantly, it gives investors the courage to go out and do this on their own.

Here at The Motley Fool, we don't allow discussion boards to be set up for companies that are not listed on one of the three major U.S. exchanges (the New York Stock Exchange, the American Stock Exchange, or the Nasdaq). This may seem prejudicial. After all, some magnificent companies such as Home Depot (NYSE: HD) and Sun Microsystems (Nasdaq: SUNW) got their starts as unlisted public companies, so-called over-the-counter stocks. Further, we do not maintain discussion boards for companies that trade below $5 per share for extended periods of time.

Are we forgoing a line of business by doing this? Possibly, but the risks of investing in a company that doesn't trade on a major exchange, isn't required to file periodic reports with the SEC, and has no analyst coverage, far outweigh the potential benefits. Don't look for the quick hit; wait until the company starts filing those reports with the SEC. No doubt it'll still be a good investment then, and you'll have the added benefit of being able to fully vet your investment decision.

Certainly there are wonderful companies that do not happen to be listed, just as there are some listed companies that are run by less-than-savory individuals. But in the end, investing is as much about risk avoidance as it is risk tolerance.

How can you protect yourself from getting snared by one of these scam artists? Follow a few common-sense tips:

  • Consider where the information about the company is coming from
  • Stay away from penny stocks
  • Do your own due diligence
  • Be wary of high-pressure sales tactics
  • Always be skeptical
Inevitably, some investors who follow all of the rules will still get bitten by scam artists. Reference the Emulex (Nasdaq: EMLX) case of a week ago, in which a highly regarded, heavily traded company got drilled based on a phony press release. There is no such thing as risk-free investing, and unfortunately those who refuse to play by the rules will remain a sad reality. Your task is simply to not be an easy mark for the scammers.

Follow the rules above, and you're most of the way there. Endeavor to become deeply familiar with your companies before and after you invest, and refuse to trade in and out on headlines, and your chances of opening your wallet for the benefit of some ne'er-do-well will drop to nearly zero. Remember, those who held Emulex and did not trade in a panic did not get hurt.

Those who got burned in these scams have a minuscule chance of getting their money back. And although they have a valid reason to be upset and to seek recourse from the perpetrators, in the end, many of these investors are getting burned by putting themselves in harm's way, whether they knew it or not.

Related Links:
  • SEC Actions on Emulex Hoax Perpetrator
  • SEC Pump & Dump Avoidance Brochure
  • Tokyo Joe Fights SEC Charges, ABCNews.com, 1/6/00
  • The Mob Takes a Hit For Securities Fraud, Fool News, 6/14/00