Are Penny Stocks A Good Investment?

Penny stock can be really appealing to speculative or new traders, as they’re cheaply priced, have the potential to double, triple, or even quadruple in price, and can increase in value quickly, as well as being able to be traded using the Over The Counter Bulletin Board.

But, are they actually worth the money?

Do they reliably appreciate in value? Or are they too unpredictable and risky to make you much money off the back of your investment? If you’ve ever thought about any of these questions, then you’re in the right place.

Read on to learn all the basics that you need to know about buying and selling penny stocks.

So What Exactly Is A Penny Stock?

First of all, it is important to know what a penny stock actually is before you even consider investing your hard-earned money in them.

In spite of their name, penny stocks are classified by the Securities and Exchange Committee) the stock of a small company that trades for less than $5 per share.

Though some penny stocks are traded on large stock exchanges, such as the New York Stock Exchange, most are traded via over the counter transactions on the electronic OTC Bulletin Board (OTC BB), or through the privately-owned OTC Markets Group.

It is worth knowing that there is no trading floor for OTC transactions (so there will be no ‘Wolf Of Wall Street’ moments if you do decide to invest in penny stocks), and all the quotations are done electronically too.

A quotation is the price of a stock, or security equity, that is quoted on an exchange.

Penny stocks are considered by traders to be highly speculative (which just means that there is a high risk of loss.

They can easily tempt traders with the falsehoods that they will grow in value exponentially, with the potential to double, triple, or quadruple their investment. However, behind the illusions, they are incredibly risky, with a really high potential for both fraud and loss of money.

This is because, typically, penny stocks are shares in troubled companies, and have tint market capitalizations (which is defined as ‘the value of a company that is traded on the stock market, calculated by multiplying the total number of shares by the present share price’).

Therefore, they tend not to be listed on major stock exchanges, like the NYSE or Nasdaq. When you take all of this information together, penny stocks are clearly highly volatile, with wildly fluctuating prices, and fraud.

Fraud With Penny Stocks

Penny stocks can easily be used to scam naive, inexperienced traders. Fraudsters who have a company to sell begin to use ‘pump and dump’ schemes (just like the ones portrayed in the films ‘Boiler Room’ and ‘The Wolf of Wall Street’, if you’re familiar).

These fraudsters use high pressure sales tactics to exploit those who are inexperienced when it comes to buying shares, and are generally more unfamiliar with trading.

Are Penny Stocks A Good Investment?

People are fooled into purchasing penny stocks, and then use disinformation to inflate the price of the stock so as to draw in more unwitting buyers (this is the ‘pump’ phase of the scam).

Then, when the price is high enough, they will then sell all of their own shares, which leads to a collapse in the penny stock’s price, and leaves all the naive traders with what is essentially a worthless stock.

This is the ‘dump’ phase of the scheme.

We aren’t saying that all penny stocks are fraudulent – in all likelihood, only a very small minority of penny stocks are frauds, but it is still worth knowing about ‘pump and dump’ scams, so you can stay aware.

Make sure to do your own research about every stock you intend to buy, even if they are only costing you pennies, so that you can make your own informed decision.

However, even when penny stocks aren’t scams, they often offer little chance for financial growth, meaning many’s value sits idle for years, with no real change.

A few penny stocks do start to gradually appreciate in value as the company steadily grows, and may even begin to trade on the larger stock exchanges, but these cases tends to be the exception to the rule.

An example of a successful penny share is Nautilus (called NLS on the stock exchange and FTSE index), which is an exercise company. It started out its life as penny stocks, but has ended up on the New York Stock Exchange.

Risks Associated With Penny Stocks

Penny stocks tend to have much higher risks than stocks carried on major trade exchanges.

Even though your investment is small, you can still lose money. We’ll take you through a list of the most common risks associated with penny stock investment:

  • High price volatility = as penny stocks have such low prices anyway, a minuscule change in the stock price can represent a huge percentage gain (which makes penny stocks so appealing). However, by the same token, when a stock makes even the smallest monetary loss, it can represent a large percentage loss.
  • Unproven, non-transparent companies = by their nature, penny stocks often come from less well known companies, and the shares don’t have a proven track record, and have generally lower reporting requirements, all of which makes it much harder to research adequately before purchasing.
  • Lower volume of trading = in contrast with stocks that are traded on big stock markets, such as NYSE or the Nasdaq, which have a large market filled with traders that are ready to buy a large amount of stock, penny stock markets are much more slow paced, and overall have fewer buyers. Trading volumes are low, so it’s a lot harder to sell your stocks. Therefore, even if you’re making profit on paper from your penny stocks, it is hard to turn this into liquid capital.

Our Advice

Investing in penny shares is totally up to you, and so long as you’re not investing vast swathes of cash, but rather dribs and drabs of pocket change here and there, you probably won’t see any huge capital loss.

But, you also won’t see any huge capital gains. If you are wanting to invest, but only have a limited amount of money, then we suggest you look into fractional shares.

A fractional share is a portion of an equity stock that is less than one full share. They are the result of stock splits, dividend reinvestment plans (humorously called DRIPs), or similar corporate actions.

Typically, fractional shares aren’t usually available on the stock exchange, but can be purchased through investing apps and online brokerages for as little as $5. They make it easy to buy into big, reputable public companies, whereas for the same amount, penny shares are far more of a gamble on an unknown company.

If this sounds like the investing route for you, then look into micro-investing apps such as Stash and Acorn.

They will help you to easily invest in the stock market of a little monthly subscription fee, and gives you access to fractional shares as well as exchange-traded funds (EFTs). Large and small brokerages also stock fractional shares.

Penny stocks are high risk, and can be high reward too in a small set of cases. However, the amount of research and knowledge necessary to reliably make money from them is high.

For beginner traders, a tried and true method like fractional shares will be easier, and likely bring you higher returns on your investment.

A buyer’s guide to investing in penny stocks –

How to position yourself for maximum gains and minimum losses.

  • Step One – decide on how much you can afford to lose. Penny stocks can be volatile and risky, so you have to set aside an amount that you can lose, and avoid putting the majority of your savings into the unpredictable penny stock market.
  • Step Two – stick to buying on well known, major exchanges. You can do this because there are a number of stocks that are traded for $1 to $5 on big stock exchanges. Buying on these big markets hugely reduce your chances of accidentally becoming the victim of a scammer, and there is higher liquidity, as there are more traders, meaning it’ll be easier to sell your stock.
  • Step Three – do your own research. It might seem obvious, but you’d be surprised about the number of first time traders who don’t do a proper amount of research. Look for companies that are traded on big stock exchanges, and have recently dipped below the $5 threshold. These types of companies are often referred to as ‘fallen angels’. Their low stock price could be due to the industry experiencing cyclical or seasonal downturns, or be otherwise successful companies that have fallen on troubled times.

Final Thoughts

Penny stocks can be volatile, and success stories are few and far between. There usually isn’t lots of information available on the companies, so it can feel a bit like a stab in the dark for new traders.

We suggest that rather than going for the penny stocks, you choose other cheap ways of investing, that historically have enjoyed solid returns.

Matt Roberts
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