Caveat Trader: Tips for Investing Online

Peter Edmonston
Special to Consumer Reports WebWatch

For the small investor, the Web can seem like a wonderland, connecting users to thousands of investing sites and dozens of low-cost online brokers. But cyberspace also provides easy access to sketchy stock advice and a confusing array of brokerage choices. Here are a few tips on navigating the Net.

See Through the Hype

"Triple your investment — guaranteed!"

If you own an e-mail account, you've probably already received a message like this in your inbox. Inside, you might have found an urgent recommendation to buy shares of a little-known company that is supposedly on the verge of a miraculous business breakthrough.

Experts say investors should be extremely wary about this kind of unsolicited tip, whether it appears in e-mail, on Web-based discussion boards or on Internet sites claiming to offer stock advice.

"Be very, very skeptical," says Deborah Bortner, director of securities for the Washington State Department of Financial Institutions. Bortner is also a founder of the Investing Online Resource Center (IORC), an educational Web site funded in part by the North American Securities Administrators Association.

Not all investing-related e-mails are scams, Bortner assures, but many come from paid promoters who tout a company's stock in exchange for cash or shares. Securities regulators require these hired guns to reveal who they are working for and how much they are being paid, but some stock promoters don't make these disclosures — or they couch them in vague, confusing language.

Just a few years ago, these e-mail scams hyped mostly dot-com stocks. But the focus has changed with the times. As oil and gas prices soared last summer, promoters sang the praises of obscure energy firms. Since the September terrorist attacks, security and defense-related companies have been stock pushers' darlings.

Be especially wary about claims of "insider" information. For one thing, insider-trading rules make it illegal for an investor to profit from nonpublic information. Moreover, these hot tips often turn out to be false. Here's a common approach: "XYZ Corp. is about to announce the acquisition of a new, multi-million-dollar contract for its next-generation electro-widgets. We expect the news will send XYZ shares up 200%!"

Bortner encourages would-be investors to corroborate any claim they read on the Internet with a reputable outside source. One place to start is the Securities and Exchange Commission's online EDGAR database, which contains financial information and annual reports from all but the smallest publicly traded companies.

Don't Get Dumped

The Internet has also provided fertile ground for the "pump-and-dump," an illegal scheme at least as old as stock trading itself.

In an online pump-and-dump, stock manipulators use Internet discussion boards and other Web venues to talk up a stock that they secretly own. They frequently target "penny stocks" — thinly traded issues not listed on the major exchanges — because their prices are highly volatile. Unwary investors often flock to buy these stocks, driving the price sharply higher. Then the manipulators unload their holdings, leaving new shareholders to suffer as the stock slumps back to its previous level, or lower.

While such schemes were more common during the bull market of the 1990s, they still pose a risk to the small investor. Since the beginning of 2002, the SEC has announced nearly 50 Internet litigation actions targeting Internet-related scams. In one case, a 17-year-old from Mission Viejo, Calif., allegedly used various Internet message boards to jack up the price of 15 different stocks that he subsequently sold at a profit of $91,000. He was identified by the SEC as the leader of an online scam that defrauded more than 1,000 people out of more than $1 million.

Another high-profile case of Internet stock fraud involved an online stock guru known as "Tokyo Joe." In early 2001, Tokyo Joe — a former burrito vendor whose real name is Yun Soo Oh Park — agreed to hand over $754,630 in profits and penalties to the SEC to settle charges that he used his highly popular investment Web site to run a pump-and-dump scheme. Park neither admitted nor denied the SEC's findings.

To see how a classic pump-and-dump works (without taking a hit to your wallet), try the IORC's online simulation. If you think you've been burned by online stock fraud, report it to the SEC here.

Brokers' Fees Add Up

Stocks aren't the only thing getting a hard sell on the Internet these days. Online brokers are aggressively wooing customers with advertisements that promise low commissions and free trades for new account holders.

Even the recent rocky markets haven't driven investors away from online trading, as shown by the approximately $1 trillion in assets still held in Web-based brokerage accounts, according to Boston-based research firm Celent Communications. Indeed, a portion of this industry includes retirement accounts, as many employers and account providers now allow clients to manage their funds and check account balances via the Web.

What investors may not realize, however, is that many brokers have been quietly raising their non-commission-based fees to compensate for weak trading revenue, says Robert Brokamp, senior personal-finance writer for The Motley Fool, which operates an investing Web site. Brokamp also helped develop the Motley Fool's Discount Brokerage Center, which offers tips on picking an online broker.

To be sure, most Web-based brokers remain far less expensive than traditional brick-and-mortar firms, Brokamp says. But investors who don't fully research a Web broker's fees may find unexpected charges gobbling up their trading profits.

For example, an increasing number of online brokers have begun charging customers when their account balance falls below a required minimum, or if they don't make a certain number of trades each month. These fees can penalize investors who avoid frequent trading in favor of a more conservative "buy and hold" approach. "Which is unfortunate," Mr. Brokamp says, "because that's exactly what many investors should be doing."

Shop Around

Low fees are enticing, but other factors — including the quality of customer service or being able to access your account through an ATM— can prove to be far more important in the long run.

To weigh the offerings among various brokers, investors can consult a broker-comparison site, such as Motley Fool's broker center. Investors can also check out the Internet quality-measurement firm Gomez, which publishes a broker "scorecard" on its site.

As with any investing-related advice, Web users should consider any potential biases that might influence broker ratings. For example, the Motley Fool's Discount Brokerage Center is sponsored by several online brokers who advertise on the Motley Fool site. The relationship has no influence on the site's content, says Brokamp, but Motley Fool considered it important to disclose the relationship.

"We've always felt that people should be up-front about any potential conflicts of interest," says Brokamp. "And that should apply whether you are a stock broker, a research analyst or anyone else."

Peter Edmonston is a freelance reporter who most recently wrote about the markets and online finance for the Wall Street Journal Online. Previously, he covered the media business for Inside.com