Q: Under capitalism, can’t a group of a few wealthy individuals acting as a fund “manipulate” a stock, causing unaware investors to buy the stocks at inflated prices, where then wealthy individuals would dump the stocks, causing prices to collapse? Would this count as fraud even though it is technically legal under the laizzez-faire capitalism? If government had to step in to regulate things, wouldn’t it violate the system?

A. People do indeed occasionally try this strategy, particularly in regards to small, illiquid stocks, often trading outside of the U.S. The situation described didn’t constitute fraud, however. If a few people agressively bought stock to drive up the price, there can have no certainty that others will follow them and buy enough to drive the price high enough for the original buyers to sell profitably. Such a strategy sounds risky, and would likely be a losing strategy by itself.

There is no such thing as an “inflated price” by the way. Prices are only determined by those willing to buy and sell. If a person believes the price that others pay is higher than what he believes it should be, he can sell or sell short that “inflated” stock. A person who buys a stock merely because it has gone up is pretty foolish and has little basis to complain about the actions of others.

If enough people have enough money, they can increase a stock price by buying heavily, faster than sellers are easily willing to accomodate. But remember, unless fools rush in afterwards with even more zeal than the original group, the original group will be the ones who lose money, as the stock would tend to settle back down afterwards, all other things being equal.

The situation which happens more often, and is more serious, is for people to buy up a stock, and then make false statements about the prospects of the company or stock, soliciting others to buy it. While this is immoral, it would probably not be illegal if these people were just private individuals exaggerating the quality of a stock. That’s why one should take free investment advice with a grain of salt, and carefully judge its source and quality. If on the other hand, such false statements were intentionally made by (for example) a stockbroker to clients, then this would simply be fraud, and would be punishable as such.

Neither of these situations pose a threat to capitalism. All business is subject to risks, and all business requires one to use good judgement.

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Andrew West

Andrew West is a Contributing Economics Editor for Capitalism Magazine. In 1997 he received the Chartered Financial Analyst designation from the Association for Investment Management and Research.