If you’ve started investing with dreams of striking it rich quick, you’ve probably heard the term penny stocks before.
Even if you don’t know what they are, you may have been tempted to invest in one, as they seem like an opportunity that’s almost too good to be true.
The problem is that they almost always are.
What Are Penny Stocks?
Penny stocks don’t actually cost a penny, (though some do). Instead, their name is a reference to how cheap they are.
The SEC generally classifies penny stocks as anything trading for under $5 a share. While you can certainly find exceptions on the NYSE and NASDAQ, these tend to have comparatively higher caps and aren’t considered penny stocks.
You will not find actual penny stocks on these exchanges. However, if you’re intent on buying them, just about any broker will be able to help. They can be found on Pink Sheets and Over-the-Counter Bulletin Board (OTCBB).
The latter is considered to be a bit more legitimate because it has some stringent requirements, but that doesn’t mean the penny stocks it lists are smart investments.
Why Do People Invest in Penny Stocks?
As you can probably tell, penny stocks don’t enjoy a very enviable reputation.
Most investors see them as the equivalent of get-rich-quick schemes. While there will always be stories about people who became rich with just a humble investment in one of these companies, those are best treated as urban legends.
Nonetheless, people will keep investing in them because they’re so cheap.
But the name also only tells half the story.
The other reason penny stocks will probably never go out of fashion is because of how volatile they are. For many investors, volatility can a big negative.
Learn more about volatility here.
In the world of penny stocks, though, volatility could mean that a stock jumps from $00.05 a share to $5 a share.
That’s the kind of legend that keeps people pumping money into these companies. Investors have all heard that someone else struck gold the same way.
The 5 Major Risks Associated with Penny Stocks
In case you’re still not convinced that penny stocks are a bad idea, here are the major risks associated with them.
Volatility. As we already touched on, volatility is one of the hallmarks of penny stocks. While fans of these stocks often tout volatility as just another word for “opportunity,” the truth is that this feature makes it nearly impossible to predict what a stock is going to do from day-to-day or even hour-to-hour.
Poor reporting standards. Another point we touched on earlier was that penny stocks aren’t listed with reputable exchanges like the NYSE or Nasdaq. This means the companies behind them don’t have to adhere to the same rigorous reporting requirements.
Some businesses offer almost no financials at all. Others report outdated figures.
It’s easy to find companies that trade just like established businesses, despite the fact that they actually list no income, revenue, or assets.
In contrast, major markets require companies to have revenue and assets.
These companies must meet a certain set of corporate governance standards, too. For example, in order to maintain their listing on the NYSE, a company must keep their share price at $2 or above. They also have at least $75 million in revenue and assets, have $75 million in market capitalization, or show positive shareholder equity worth at least $4 million.
No reliable sources of information. That last problem wouldn’t be as bad if there were reputable third-parties out there willing to do the legwork and conduct thorough investigations.
Unfortunately, there’s just not a big market for that kind of reporting in the world of penny stocks. If there was, there probably wouldn’t be much of a market for penny stocks, either.
Whereas cable TV and countless publications are constantly reporting on the major exchanges, this kind of information just isn’t available for penny stocks, which means you have to take a major leap of faith in order to invest.
Keep in mind that these last two risks don’t necessarily mean that every penny stock company is doing something wrong or illegal.
But even if you “trust” the company, just know that doesn’t mean they won’t turn out to be a terrible investment despite their best intentions.
The market is largely illiquid. A lot of times, you’ll find that there is literally only one other party to take the other side of your trade when dealing with penny stocks. Often, this is because that disreputable party has been manipulating the market, a scam we’ll touch on next.
Even if a scam isn’t at play, the problem of an illiquid market is still one that is prevalent with penny stocks.
A market that’s considered illiquid is one that’s considered to sell assets because of their expense, lack of interested buyers, or other reasons.
When you either go to buy or sell a stock, you may actually move the market, either hurting your profit or forcing you to pay more than you had intended.
Stick to Reputable Opportunities
There’s no surefire way to get rich quick. A strategy to consider? Investing small amounts of money, over time, into a diversified portfolio of stocks, bonds, and funds.