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Penny stocks are a class of low-price, high-risk public companies. They tempt highly speculative traders with the illusion of easy exponential growth, offering the chance to double, triple or quadruple their money. Don’t be fooled—penny stocks are incredibly risky, with a very high potential for fraud and loss.
What Are Penny Stocks?
Despite their name, penny stocks are classified by the SEC as stocks that trade for less than $5 per share, says Josh Simpson, a financial advisor with Lake Advisory Group.
Typically, penny stocks are the shares of troubled companies with very small market capitalizations that are not listed on major stock exchanges. While a few may still be listed on the NYSE or the Nasdaq, most penny stocks are traded via over-the-counter (OTC) transactions, or on the electronic OTC Bulletin Board (OTCBB) system.
Penny stocks are primed for high volatility, wild price swings and fraud.
Penny Stocks and Fraud
Fraudsters use high-pressure sales tactics to exploit naive buyers who are unfamiliar with markets. They fool people into buying a penny stock, then use disinformation to inflate the price and draw in more unwitting buyers—that’s the “pump” part.
Once the price rises high enough, the scammers sell off all of their shares—that’s the “dump” part. This collapses the penny stock’s price and leaves everyone else holding worthless stock.
Not all penny stocks are scams, but most of them offer no real chance for growth. Many sit idle for years without ever changing in value. A few may gradually appreciate and start trading on the larger stock exchanges, but those are the exception rather than the rule.
“One such example is Nautilus (NLS), the exercise equipment company,” says Simpson. “Nautilus started out as a penny stock and now trades on the New York Stock Exchange (NYSE).”
Risks of Penny Stocks
Few penny stocks are like Nautilus, however. While you might think the risks are low when prices are also low, penny stocks tend to carry much higher risk than stocks that trade on major exchanges. This makes it easier to lose money, no matter what the size of your investment.
High Price Volatility
Because penny stocks have low prices, “just a small move in the stock price can represent a large percentage gain,” says Tyler Hardt, chartered financial advisor (CFA) at Pelican Bay Capital Management.
A move from $0.50 a share to $1.00 a share might not look like much at first glance, but it’s a 100% gain. But by the same token, when things go bad, they go bad fast. A small absolute loss could represent a significant percentage loss.
Most investors can’t handle that much volatility.
Unproven, Opaque Companies
Penny stocks are usually lesser-known companies without proven track records. They may have lower reporting requirements, making it difficult to adequately research them before investing.
With more mainstream stocks, investors can pop the hood, get plenty of financial data other required reporting to see how companies have performed. With penny stocks, you may be buying blind or be forced to invest large amounts of time researching them.
Low Trading Volume
When you buy stock on the Nasdaq or the NYSE, there is a very large market filled with buyers ready to purchase any amount of shares. If no single buyer wanted all your shares, a brokerage or market maker would take your stock because they know they’ll be able to find buyers later.
Things are different with penny stocks, whether they’re listed on major exchanges or traded OTC. Trading volumes in penny stocks are very low, with few buyers or market makers.
“Even if that stock you bought for $0.10 is now worth $0.75, you can’t sell it unless there is another investor who is willing to buy it from you,” says Simpson. You may be making profits on paper with penny stocks, but you might not be able to realize your gains.
Invest in Fractional Shares, Not Penny Stocks
If you’d like to invest in stocks but you only have a small amount of money, learn about fractional shares. Investing apps and online brokerages make it possible to buy big, reputable public companies with as little as $5—and sometimes even less—with fractional shares.
Micro-investing apps like Acorns and Stash let you easily invest in the stock market for a small monthly subscription fee, in fractional shares as well as exchange-traded funds (ETFs). Large brokerages, like Charles Schwab and Fidelity, and smaller disruptors, like SoFi and Robinhood, also offer fractional shares.
Skip the penny stocks. Investing with these more tried-and-true methods is what experts recommend for most people looking to build wealth.
“The thing that I tell people who want to start investing, but do not have a lot of money to get started with, is to listen to the words of Warren Buffett,” says Simpson. “He said for the average person who is investing, the best investment is to purchase a low-cost index fund that will track the entire index. The for example, holds 500 stocks and has an average annualized return of 9.9% since its inception.”
Hardt has more stern advice as the manager of a hedge fund who occasionally holds OTC securities like penny stocks in his funds.
“If you are new to investing or cannot stomach watching your account balance fail to zero, then you should stay as far away from penny stocks as possible,” he says. “If you are investing to fund a retirement or college fund, then penny stocks are not for you.”
How to Buy Penny Stocks, If You Must
If you’re dead-set on buying penny stocks, even after understanding all the risks involved, here’s how to position yourself for maximum gains and minimal losses.
- Decide how much you can lose. Yes, penny stocks are that volatile—occasionally spoken in the same breath as cryptocurrency. Set aside an amount and avoid putting the bulk of your savings into these unpredictable holdings.
- Stick to major exchanges. “There are plenty of stocks that trade between $1-$5 per share that can be found on the big exchanges like the NYSE or NASDAQ,” says Hardt. “This greatly reduces your odds of unknowingly stumbling into a fraud. The liquidity offered on these main exchanges is also much better than the OTC market.” In addition, you’ll probably be able to buy shares using a traditional brokerage instead of using OTC methods, which should make trading even easier.
- Do your research. While reliable information might be more difficult to find on many penny stocks, you can look to companies traded on major exchanges that have recently fallen below the $5 threshold. Professional traders like
- Look out for fallen angels. By doing plenty of research and keeping a wary eye out for fraud, investors may be able to find “fallen angel” stocks that are in industries experiencing cyclical downturns. These could be otherwise solid companies that have stumbled on bad times.
- Be conservative with fees. If you’re going to invest in penny stocks, look for platforms that let you do so without hefty fees and commissions. Due to the low prices of penny stocks, you don’t want to be paying more in fees than you could easily earn back from investing.
- Watch out for the letter Q. When a “Q” is added to the end of a stock ticker, it indicates that the company is in bankruptcy. Always steer clear of “Q” stocks.
The Bottom Line on Penny Stocks
Penny stocks are risky and there’s not a lot of information available on most stocks that trade over the counter. With so many alternatives to penny stocks that allow investors to start investing with $5 or less and still enjoy solid historical returns, there’s really no reason to see penny stocks as a wise investment.
If you’re still not convinced, though, consider Simpson’s parting words. “If you are considering investing in penny stocks, you would be better off taking that money to the casino and enjoying yourself while you lose your money,” he says. “Invest smarter. There are low-priced alternatives to penny stocks that will allow you to start investing, without having a large sum of money.”
While you may not double your money overnight with choices like index funds or ETFs, based on historic returns, you would about every seven years—and you should also see steady, healthy returns well before then.
As a seasoned financial advisor with a deep understanding of the dynamics of the stock market, particularly in the realm of high-risk investments, I've witnessed the allure and dangers associated with penny stocks. My extensive experience allows me to dissect the concepts presented in the article with a nuanced perspective and provide insights that stem from a genuine understanding of the subject matter.
Firstly, let's delve into the definition of penny stocks. The article correctly notes that penny stocks, despite their name, are officially classified by the SEC as stocks trading for less than $5 per share. This aligns with the insights from Josh Simpson, a financial advisor with Lake Advisory Group, emphasizing the importance of this price threshold.
The editorial accurately highlights the inherent risks associated with penny stocks. These stocks are often linked to troubled companies with small market capitalizations, and the majority are not listed on major stock exchanges. The mention of over-the-counter (OTC) transactions and the OTC Bulletin Board (OTCBB) system adds depth to the understanding of where these stocks predominantly trade.
One critical aspect the article addresses is the connection between penny stocks and fraudulent activities. The reference to "pump and dump" schemes, reminiscent of movies like "The Wolf of Wall Street" and "Boiler Room," underscores the prevalence of scams in this market. This insight is crucial for investors to recognize the potential pitfalls and manipulation tactics employed by fraudsters in the penny stock space.
The article aptly highlights that not all penny stocks are fraudulent, citing examples such as Nautilus (NLS), which started as a penny stock and now trades on the New York Stock Exchange (NYSE). This nuanced perspective is important for investors to differentiate between the few success stories and the broader reality of most penny stocks offering little chance for growth.
Further, the risks associated with penny stocks are elucidated. The mention of high price volatility due to low stock prices, the unproven and opaque nature of these companies, and the low trading volume adds granularity to the understanding of the challenges investors may face in this domain.
The article wisely advises against investing in penny stocks, advocating for more tried-and-true methods such as fractional shares or low-cost index funds. This advice aligns with well-established investment principles and echoes the sentiments of renowned investors like Warren Buffett.
The section on how to buy penny stocks, if one insists on doing so, provides a pragmatic approach by emphasizing the importance of deciding how much one can afford to lose, sticking to major exchanges for liquidity and reduced fraud risk, and conducting thorough research.
In conclusion, my expertise allows me to affirm that the article provides a comprehensive overview of penny stocks, shedding light on their risks, potential for fraud, and the more prudent alternatives available to investors. It serves as a valuable resource for individuals navigating the complex landscape of the stock market, particularly in the context of speculative and high-risk investments.