We just celebrated July 4 in my home state, Maryland, where the only firework a citizen can legally light is a sparkler. Yet, on the evening of July 4, I could hear the pop, pop of nearby fireworks from every direction.
The point is that the legislators make laws, but people choose whether to follow them or not. The same is true in the world of investing. The SEC passes regulations and laws, but that doesn’t mean the rules are followed.
Good people fall for investment scams on a regular basis, and sometimes, they fall hard. People always tell you that if it sounds too good to be true, it probably is. But it’s much easier said than done.
When I was an ambitious 20-something, I fell for what – although never officially proven – was likely a scam.
I fantasized about how this one stock would change my financial future and saw myself buying rounds of beer at happy hour on Friday night, all the while feeling pretty smart for having read this article.
I read an article in an investing newsletter and it sounded like a sure thing. The story was juicy. A well-established mining company had just discovered a new deposit that was bigger than any other company had discovered in the last three decades. They were about to start drilling and shareholders who got in now would make a fortune on the stock as soon as the mine started producing.
The investing guru who penned the story was a mining stock expert with an “insider” scoop. He was oozing with enthusiasm about this being the last stock his subscribers would ever have to buy. His claim was along the lines of, “You can retire on the profits you’ll make on this one stock!”
The only catch was that you had to get in quickly before other investors realized the significance of this discovery.
I was living paycheck to paycheck at the time and didn’t really have any money to invest. I knew very little about stock investing, and nothing about the ins and outs of mining. I had done no research about this guru or his stock picking track record.
But this was a sure thing! I was convinced I should plunk down as much as I could spare. I fantasized about how this one stock would change my financial future and saw myself buying rounds of beer at happy hour on Friday night, all the while feeling pretty smart for having read this article. I was emotionally invested and bought shares of the mining company.
You can probably guess what happened next.
A week after I bought my shares, the massive price hike the stock was experiencing stalled. And then it tanked…quickly. As it turns out, I bought at the peak of the bell curve and rode my investment the rest of the way down the hill.
It was then that I learned about a form of securities fraud called “Pump and Dump.” That’s when an advisor purchases a significant number of stock shares at a cheap price, then inflates the price of the stock they own through false or misleading positive statements (to pump up the share price). They then sell (or dump) the shares they own at the hyped-up inflated price.
The investors who bought into the hype are left holding shares worth a lot less than they paid. Meanwhile, the advisor exits their stock position with profits in hand and the per share price drops on the remaining outstanding shares.
Like civilians setting off fireworks in my state, a pump and dump scheme is illegal — but that doesn’t mean it doesn’t happen or is always prosecuted when it does. I'll never know if this advisor actually committed securities fraud. But it did seem suspicious at the time and the stock price movement followed the pattern of a pump and dump scheme when charted.
Here’s What I Learned:
I thought buying stock, any stock, was investing. But I was speculating – swinging for the fences betting on a long shot mining discovery.
After this sobering experience, I started studying the world of investing to find strategies and principles that would actually work. And I looked at what the investing legends like Warren Buffett and Jack Bogle practiced.
Here were the three lessons I took away from this experience.
Do Your Due Diligence
Newsletter gurus are generally not SEC-registered investment advisors. They don’t actually need any credentials, formal education or license. In fact, most services publishing investment advice and guidance are exempt from SEC oversight and regulations.
That’s because the industry players are simply publishing investment information to a group of subscribers or for free on the internet — not giving personal investment advice. That means that scams perpetrated by many advisors are not even on the radar of the SEC.
The lesson: Do proper due diligence before investing in any opportunity (especially those that promise high returns with little or no risk). Investigate the source of the advice you're considering taking. If you sniff out scams and potentially illegal activities…run the other way.
Invest for the Long Term
Buffett’s favorite holding period is forever. Shooting for the fences on a one stock tip is the antithesis of long-term investing. It’s not investing at all – it’s speculating, a concept I didn’t understand until after I made this mistake.
Mining stocks in general are speculative investments. They’re cheap to buy and can experience wide swings in price. I thought buying stock, any stock, was investing. But I was speculating – swinging for the fences betting on a long shot mining discovery.
Quick gains are possible in the stock market, but the average investor doesn’t come out on top when investing for short-term profits.
The lesson: I’m in this for the long haul. Invest, don’t speculate.
Don’t Invest in What You Don’t Understand
This is probably Buffett’s most famous advice. No matter how rich he has become, he still follows it himself.
It’s plain and simple: If you don’t know enough about the company, their business plan/practices and the industry in which the company operates, steer clear of investing in their stock.
The lesson: Don’t be overcome by greed or a sensational story. Invest only in what you understand.
Buy Index Funds
The late Jack Bogle revolutionized investing in 1975 with his invention of the index fund. If you don’t have the time, expertise or desire to do the proper due diligence required to be successful as a stock picker, your best move is to park your money in a market index fund.
Even if you do have time and some expertise, buying individual stocks is putting all your eggs in a few baskets. An index fund, on the other hand, is a group of stocks put together to mirror the movement of entire stock market benchmark index, like the S&P 500.
For most of us, stock market investing is a passive endeavor. If we’re honest with ourselves, we’ll admit that we’re not qualified to pick stocks successfully. Minimizing risk of loss, matching the returns of the overall stock market and lowering the cost of investing are the goals of index funds. They are also the best strategy for the average individual investor.
The lesson: For the bulk of my stock portfolio, a market index fund is my best bet.
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