Are cable-TV financial pundits guilty of pump and dump schemes?

A member once asked me, “why is it that recommendations from the various pundits, CEOs, brokers and money managers so often go down rather than up after they tout their stuff on [a Canadian TV financial channel]? Are these guys above pumping and dumping?”

“Pumping and dumping” is far too strong a term. After all, that’s a form of stock fraud.

Pump-and-dump scheme operators usually focus on small and little-known stocks with few if any tangible assets. Perpetrators of the scheme 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. 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. Though pump and dump schemes are illegal, successful prosecutions are rare.

The wrong kind of stocks

In contrast, 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.

Sometime 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 TV commentators focus on small-cap stocks. These stocks are more volatile and less widely traded than the well-established 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 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.

4 tips for successful investments that don’t involve pump and dump schemes

Always ask yourself, “What can go wrong with this investment?”

What upcoming event, technology or political trend could derail its profitability? In other words, don’t fall in love with a stock just because it has a great track record. When a company’s profits have been rising for years, its stock price will always be expensive in relation to its per-share profit. If something goes wrong and profit starts to erode or, worse, turns into a loss, the stock can go through a devastating drop. Too much enthusiasm for a favourite can lead investors to ignore its risks and price it as if those risks don’t exist.

Remember that high profits attract competition.

This is related to rule #1. When a company is making a lot of money, you can be sure that other companies are making plans to enter its market with a competitive product that is slightly cheaper, or better, or more effectively marketed or whatever. Unless demand is exploding, this is bound to limit sales growth and depress profit margins.

Always try to apply your judgement, but don’t overrate it.

If you spot a stock that seems to have great prospects, go ahead and buy it. Don’t wait for your broker or the Internet or business television commentators to begin talking about it. If you have been successfully investing for a number of years, your judgement has value and you should trust it. But don’t go overboard. After all, no matter how sure you are that a stock is a winner, you can still be wrong.

There are no sure things in stock picking, even when the market is up, and certainly not when it’s down. That’s why we always advise you to keep any one stock you buy within reasonable bounds (5% or less of your overall portfolio is a good benchmark.)

Resist the temptation to copy prominent investors.

Sometimes you’ll hear that a stock is a good buy because some prominent investor (a company, family or individual) has a stake in it.

However, it’s important to remember that prominent investors don’t expect to profit in every investment they make. They do make mistakes. For that matter, sometimes they invest for strategic or political reasons, rather than for profit.

To profit yourself by copying the decisions of prominent investors, you have to copy what they do with the bulk of their money, not with token amounts of it. That’s more difficult to do than it might seem at first glance, since prominent investors often keep their best investments hidden until they want to sell.

Have you ever witnessed a pump and dump scheme happen to a stock you were watching? Share your experience with our community in the comments.