Having some investing knowledge will help you stay out of money-losing investments like pump-and-dump stocks and stock promotions

The operators of pump-and-dump schemes usually focus on small and little-known stocks with few if any tangible assets. Perpetrators already have a holding in the company’s stock. They plan to “pump” demand for their shares by circulating false, misleading or greatly exaggerated statements and predictions about the stock. Then they plan to “dump” their holdings after their hype has led to a rise in the stock’s price.

The stock usually collapses within a few weeks or months. Even though the practice of selling pump-and-dump stocks is illegal, successful prosecutions are rare.

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Pundits are not necessarily guilty of promoting pump-and-dump stocks….however, following pundits in general can be a bad idea

In contrast, cable-TV guests and broadcasters operate well within the bounds of the law, usually with honest intentions. They want viewers who act on their advice to make money. In most cases, the guests and/or their clients already own the stocks they recommend. Some time after guests appear on the program, they will undoubtedly decide to sell. (They’ll refrain from selling immediately after their latest televised recommendation, to avoid the appearance of selling into demand stirred up by their recommendations.) But the risk of following their advice has more to do with the kind of stocks they recommend, rather than their reasons for recommending them.

Lots of cable-TV commentators focus on small-cap stocks. These stocks are more volatile and less widely traded than the well-established Successful Investor companies we favour, so they can put on more impressive gains in a short time. Of course, this volatility works two ways.

If they run into a business setback, small-cap stocks often go into a deep slump. Recovery can take a long time, if it happens at all. In addition, these stocks may have already made big gains before you hear about them. The price you pay may be high in relation to a conservative assessment of their long-term value.

To sum up, if you buy stocks based on tips from cable-TV commentators, you face an above-average risk of buying thinly traded, low-quality junior issues that have already gone through an undeserved rise, and are likely to slump deeply and stay down if they run into a business setback. That’s not a guarantee of poor results, of course. But it tilts the odds against you, regardless of the intentions of the advisor.

In addition to pump-and-dump stocks, watch out for stock promotions, which frequently happen with penny stocks

A penny stock promotion is launched by penny stock promoters, usually by their marketing department or public relations firm. Penny stock promotions are created to make a penny stock appear more valuable than it actually is. That’s because it’s much easier to launch a penny stock promotion than it is to create a successful, lasting business.

Penny stock promotions often try and tie penny stocks to major household names because penny stock promoters have an easier time selling a penny stock when a major mining company has agreed to look at their mining claims, or if a household-name multinational has agreed to evaluate their revolutionary software or “cloud” application.

When they get any kind of deal with a major, penny stock promoters go to great lengths to make it seem bigger than it is. In fact, when a penny stock shoots up on the news of big-company involvement, and the property/program/revolutionary software is still in the early stages of development, it’s often a good time to sell.

Knowledge and education will help you avoid pump-and-dump stocks and other investing schemes

Early on, you may learn a few things about investing, and form some opinions. But your investing education really begins after you start to recognize just how much you don’t know (isn’t that how all real learning begins). When you reach that point, you’ll start to look at a much wider range of data and indicators. But, more importantly, as a Successful Investor, you’ll start to pay more attention to investment selection and portfolio structure, and far less to deciding when to buy and sell.

At the Successful Investor we feel that stocks that have been paying dividends for over 10 years are some of the safest investments you can make. Dividends are a sign of quality and a company’s financial health. Types of stocks that we consider to be safer investments include Canadian banks and utilities.

There are also a host of other key indicators to determine if a stock is a safer investment, like management integrity, its growth prospects and its stock price in relation to its sales, earnings, cash flow and so on.

For a true measure of stability, focus on those companies that have maintained or raised their dividends during an economic or stock-market downturn. We think investors will profit most—and with the least risk—by buying shares of well-established, dividend-paying stocks with strong growth prospects.

Why do you think pump-and-dump stock schemes aren’t prosecuted more?

What investment schemes have you managed to avoid in your investing career? What tipped you off?