The math behind Wolf of Wall Street and how it could affect you
There are several lessons you could take from Wolf of Wall Street, mostly including things like ‘don’t drive under the influence of drugs’ and ‘committing fraud is a really bad idea’. But there are also less general lessons to be learnt from the business practices depicted: such ‘pump and dump’ strategies really exist, and they really burn if you get caught out by them.
What is the ‘pump and dump’ strategy?
Essentially, it’s trying to turn a profit by forcing up the price of stocks and then
The strategy shown in the film boils down to three steps:
- Get wealthy, reliable clients to buy large amounts of stock issues from his firm by guaranteeing a certain return on the investment – the rat holes.
- Sell further stocks to less affluent clients, driving the price up.
- Once a certain increase in price has been reached, instruct the ‘rat holes’ to sell up. Those clients take their guaranteed return, and the firm pockets the difference.
At its core, that’s how making a profit on the stock market works. You buy your shares, and sell either when you no longer think it’s a useful investment or you want to cash in as the price rises.
Unfortunately, the deliberate guaranteeing and artificial driving up of the stock price means that the literal middle man in the above strategy loses out. The less affluent clients who were talked into buying the second wave of shares see their investment crash and burn. It’s the already wealthy clients brought in at the first step who profit, along with the firm itself.
Even more unfortunately, the scam works because the stock brokers manipulate these investors into it. A broker is supposed to provide advice and make decisions with reasonable certainty that any investment is in the client’s best interests. Talking up a stock as the hottest investment, knowing that it’s part of a scheme to inflate prices in preparation to cash in and let the whole thing crash, doesn’t really meet that specification.
How to avoid the scam
It might not be the happiest advice, but if it’s too good to be true, then it almost certainly isn’t. These scams work by the dropping of ‘hot tips’, either directly or by “accident”.
Hint: if you pick up a message on your answer machine detailing the best new investment, apparently to the wrong number? Well, sure, it could be an honest mistake and you might just be getting a real scoop.
More likely it’s only a ‘wrong number’ because someone programmed the call to give the tip off to as many people as possible, apparently by accident. I mean…if you had a tip off to pass on to someone about something you thought was going to be a cast iron investment, wouldn’t you just say to call back ASAP, rather than leaving an answer phone message?
It sounds obvious, but this very strategy has been successfully employed in pump and dump scams before. Keeping your wits about you and always considering why someone would be passing on advice on a certain investment can help keep you from falling prey to the Wolf of Wall Street.