The investing industry is one that is plagued with a history of deceit. Fortunately for the average investor, the Securities and Exchange Commission is there to protect us from these deceitful companies. Public companies that you can invest in are required to report important documents of information to the SEC so that this information is public and there is transparency in the market. Without this requirement, public companies could claim they have high revenues when they don’t, and anyone invested in that deceitful company would find their stock worth nothing when it became known that the company is just a shell, producing little to no revenue. If this sounds scary to you, then this is exactly what you’re getting when you invest in penny stocks!
Penny stocks exist on a different market exchange that is mostly unregulated by the Securities and Exchange Commission (Known as the OTCBB and Pink Sheets). The chances of finding a legitimate penny stock are very low. Most penny stocks are simply shell companies, that go through cycles of momentum and stock price because of the individuals who trade them. One day a penny stock can be up 300%, then the next day it can be down 90%, yet literally nothing at all has occurred in the company. Here are the reasons to stay away from the Penny Stocks:
Low Liquidity, High Risk
Unlike the stocks listed in major exchanges such as the S&P 500, penny stocks have very low daily volume. What this means is that you can buy shares of a penny stock, and in some cases have no one to sell it to! On average, penny stocks have volume equivalent to a few thousand dollars being exchanged every day. You want and sometimes need good liquidity in a stock so you can make a quick entry and exit, especially in penny stocks where the stock price can tank on a whim.
Pump and Dumpers
If you ever receive an email or possibly an advertisement that claims you need to immediately “invest” in a penny stock, you’ve been a target of pumping and dumping. The idea behind this is to create unfounded hype for a penny stock the pumper already owns, then as his victims buy into his hype and drive up the price of the stock significantly, the pumper sells his shares for a large profit. Meanwhile, those that bought into the hype will quickly lose their money as the upward stock momentum drops and the stock price heads south.
Inability to do Homework
Penny stocks differ from the stocks on major exchanges in that they have little to no following at all. You almost never find a penny stock being talked about by the financial media. There is usually no analyst opinions on penny stocks, which should put up an immediate red flag. If this company were actually worth something, wouldn’t analysts be interested in it?
Enjoy the Ride
Penny stocks are known for their wild and violent swings in momentum. You could walk away from your trading station/computer for an hour and come back and realize your penny stock went up 25%, then plummeted into the red. With penny stocks, you need to spend many hours every day watching your positions, otherwise you risk missing the golden opportunity of profit.
Unfortunately, I know this article probably won’t sway any new investors to avoid penny stocks. The lure of rapid, high percentage gains is too strong for naive investors. But hey, if you end up losing half your portfolio from a penny stock, don’t say I didn’t warn you.
Good warning. “Investing” in penny stocks is exactly like gambling at the casino. You can make money by letting it ride, but you have to be lucky and get out at the right time. When I first started seriously investing, I set aside some play money. This was after funding the 401(k). I used it to try some “penny stocks” that were around $1 or $2 a share. I also practiced buying options and selling covered calls with this money. This was back in 1998-2000 when things in the market were great. I actually made some decent money in the penny stocks, turning $2000 into $5000 after a few months, but then I stopped before losing. I never made big profits in the options game, and probably broke even. I used the money I made to buy an engagement ring. I played the “rolling stocks” game (you can google that to learn more) with GTOS, I just looked it up now and it no longer is trading. The one fun thing is like you mentioned, the low volume. Some days, I was all or most of the volume and it was funny to see all of my trades reported to the world to see. Anyway now I practice and preach the long term buy and hold strategy using low price index funds in my own blog.
LOL. Yeah it is pretty funny when you are the only active shareholder in a penny stock in a given day.
The only good thing I can say about penny stocks is that trading them helps you build discipline. If you can handle the ups and downs of penny stocks, you can easily handle the day to day changes in the big board stocks.
Wow, thank god for this article! I got an email last week with what looks like a “pump and dumper” scam you mentioned. Glad I didn’t invest yet because what you described sounds just like my email.
Thanks,
James
Wow, I can’t thank you enough for this article.
I learnt my lesson, sitting on a 10k loss. Thankyou for the article.
I just got in tuesday and two stocks are down one is up… I’m a little scared.
should I dump it all?
Investing in penny stocks can be detrimental because it’s a market of high returns and also high risk. However, if you go through a reputable broker with a strong research department, they can do the homework for you and find the real gems with growth potential.
Greetings! I really respect your highly original blog and will tell all my friends about it. Just in case you’re interested in trading penny stocks, do take a look at my new website. Cheers.
Investing in penny stocks is just flat out scary to me. You also are at risk of the stock getting de-listed or the company just declaring bankruptcy.
Thanks for sharing your expertise on this subject.
@Katie, you need to do your own research. But, the rewards can be great!