Penny Stocks: 5 Reasons to Avoid This Investment

Penny stocks are sometimes seen as a way to get rich quick. They don’t cost much to own, so people see trading penny stocks as an easy way to start investing. 

If you’re buying shares at a super low price, it wouldn’t take much of an increase to get rich, right?

In general, you should avoid penny stocks like the plague.

But why are penny stocks so bad that you should avoid them altogether?

Unfortunately, there are many reasons why penny stocks aren’t usually a great investment. 

Look:

Sometimes, it seems like penny stock investing is like pulling the lever on a slot machine. Yes, there can be times where you can make money trading penny stocks. At the same time, you could (and more likely to) lose your entire investment. 

Here’s what you need to know about penny stocks and why avoiding penny stocks is probably your best move.

What Are Penny Stocks?

The definition of a penny stock depends on who you ask. In general, a penny stock is a stock with a very low stock price. 

For some people, a penny stock is a stock that has a share price per share of less than a dollar. 

However, the Securities and Exchange Commission (SEC) defines a penny stock as a very small company that has a stock that trades at less than five dollars per share.

The low stock price of penny stocks makes them attractive to new investors because you can buy many shares relatively inexpensively. 

The thinking is that if the share price rises, you could make a lot of money by owning many shares. The opposite is also true. If the price decreases, you could lose a lot of money, too.

Where to trade penny stocks

Penny stocks don’t usually trade on traditional stock markets.

Instead, they typically trade on the Over The Counter (OTC) Bulletin Board or Pink Sheets listing services. 

The over-the-counter markets and pink sheets markets are not major stock exchanges like the New York Stock Exchange (NYSE).

Rather, they are for unlisted stocks that could not qualify for a major exchange in most cases.

1. Penny Stock Scams

One big reason to avoid penny stocks is penny stock scams.

Common scams include pump and dump schemes and chop stocks.

Pump-and-dump

Pump and dump schemes are fairly simple to understand, but difficult to spot. 

In this scheme, a person buys a large number of shares of a penny stock. Then, they hype up the stock and get others to buy it, which increases the share prices. 

Once the stock rises high enough, the original investor will sell all of their stock at the higher price. 

This earns the original investor quite a bit of money but likely leaves the investors -- who helped increase the stock price -- with large losses.

Chop stocks

Chop stocks are another common problem. 

In this situation, a less than reputable broker will buy shares of a penny stock that isn’t frequently traded at a deep discount to the current market price.

Because these stocks aren’t traded often, it’s harder to determine a fair or market value.

Then, the broker resells the shares they bought at a discount to unsuspecting buyers at a much higher price.

The broker makes a large profit. It also sticks the buyer with shares that aren’t likely worth what they bought them for

2. Trading Costs Can Be Expensive

Trading penny stocks can be expensive.

Let’s say you want to buy 100 shares of two companies.

  • Company A is listed at $0.05 per share.
  • Company B is listed at $5.00 per share.

The total purchase price would be $5 for Company A and $500 for Company B.

However, you’re likely going to be charged the same trade fee for both purchases at many brokerages.

Let’s say the brokerage charges $5 per trade:

  • In the Company A example, your trading fee is equal to 100% of your purchase price.
  • In the Company B example, the trading fee is only 1% of your purchase price.

In addition to the usual trading fees, some brokerages charge an extra fee for stocks valued below a certain price. 

This adds even more than the usual costs.

When you compare it to the investment you’re purchasing, the trading fees can be a larger percentage than if you purchased a traditional investment.

3. Lack of Company Information for Analysis

While certain penny stocks may be required to file financial statements with the SEC, not all penny stocks must do so.

At the same time, all stocks listed on the major stock exchanges, such as the NYSE, are required to disclose their financial statements.

The lack of financial information on penny stocks is a major red flag.

If you don’t know the accurate financial status of a company, how can you judge if it is worth investing in?

Still:

People invest in penny stocks because they believe they have a hunch that can make them rich.

In reality, they may be investing in a company with no financial statements that’s almost insolvent.

4. Harder to Buy and Sell

Major stocks have many investors buying or selling their shares on any given day.

Penny stocks, on the other hand, might not have many shares of their stock outstanding. There may be days when a penny stock doesn’t have any stock trades at all. 

This can be problematic for many reasons.

First, in order to buy a share of stock, someone must be willing to sell it to you. If there are no shares available to purchase, you can’t buy them.

The bigger problem comes when you’re ready to sell. If you list your shares for sale and no one is willing to buy them, you could be stuck with them. Finding a buyer can be difficult.

Another thing to consider about this is the ability to trade, or the liquidity of a stock, could have other impacts.

If you want to buy more shares than are currently available, you could end up driving the stock price up to purchase the shares you want.

The opposite is also true.

If you absolutely have to sell you shares and few people are buying them, you could easily drag the stock price down as you sell.

5. Returns Might Not Be as Good as You’d Hope

Companies considered penny stocks aren’t penny stocks because they have a strong company. Instead, they’re likely struggling to survive.

Unfortunately, this usually doesn’t end up well for long-term investors. While some struggling companies do turn around and become successful again, others fail.

If you’re investing for the long term, there’s a good chance that many penny stocks you invest in may completely lose their value. This would leave you with nothing.

Even when you consider the short term, you may not earn much return from penny stocks.

An example

Let’s say you own 10,000 shares of a company. You bought those shares for $0.10 each. That means you invested a total of $1,000 in the shares.

The stock price creeps up to $0.15, a 50% return on investment, and you wisely decide to sell. That gives you a sales price of $1,500.

That initial $500 profit is reduced by your buying and selling fees of $5 per trade, to leave you a total profit of $490.

While a $490 return is nice, it isn’t a ton of money in the long run. If you hold the investment, it could easily decrease in value to $0.05 per share, leaving you with a $500 loss.

To make matters worse, if you want to earn even more money you have to invest larger amounts upfront.

This opens you up to even more risk of losing money if the penny stock you pick decreases in value.

Better Ways to Invest for the Long Term

If you shouldn’t invest in penny stocks, what should you invest in? 

Each individual should invest based on their goals. Consult with a fiduciary financial advisor to come up with a specific plan for your situation.

That said:

There are some general rules of investing that can help you invest successfully.

Diversification

First, you should invest in a diverse portfolio of investments.

This is also known as not putting all of your eggs in one basket.

Many people accomplish this by investing in index funds that track large portions of the market, such as the S&P 500.

By not investing in only one or two stocks, you’re spreading out the risk.

If you own 500 stocks through an index fund, one could drop to zero and it wouldn’t make a major dent in your portfolio. 

If you only own two stocks in equal dollar amounts and one drops to zero, you would lose 50% of your portfolio.

Keep costs low

Next, invest in low-cost investments.

By lowering your cost, you keep more of your money over time.

Due to the power of compounding returns, lowering your cost could result in a much larger nest egg in retirement.

Still Want to Invest in Penny Stocks?

If you’re still tempted to invest in penny stocks, it isn’t the end of the world.

Just don’t put your entire portfolio in penny stocks. 

Simulate your penny-stock trades

Try investing in penny stocks with a simulator or by pretending to buy and sell shares.

Track the price quotes and see how you’d fare if you actually invested in the penny stocks.

Find out if you would have earned money or lost money on the stocks that you traded.

This can show you why you should avoid penny stocks without losing any money. If that doesn’t work, here’s another idea.

Then:

Instead of using a simulator, pick a very small percentage of your portfolio, such as 5% or less, to experiment with penny stocks. Maybe you’ll hit a home run. More likely, you’ll lose money. 

Over time, you’ll eventually figure out if penny stocks are for you or if you’re better off avoiding penny stocks without losing your money.

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