One of the most consistent mistakes a significant number of inexperienced investors make is to be drawn to a type of common stock known as penny stocks. At first glance, the reasons for this (ultimately dangerous) appeal are legion but almost always come down to the fact that penny stocks appear to fluctuate tremendously in price, which appears to lead to an opportunity to generate a very high return quickly.
Unfortunately, as with all investments, appearances are quite deceiving. It often turns out to be precisely the opposite of a high return as penny stocks can wipe out your savings in the blink of an eye.
- The phrase "penny stock" is used to describe shares of a company that trades for very low amounts—typically, between $0.01 and $2.00.
- The reason some people are drawn to investing in penny stocks is that these companies fluctuate wildly in very short periods of time.
- However, even if you bought at $0.25 and tried to sell at $1.50, you may not get any buyers.
- The risks of penny stocks are simply too great to offset any perceived benefits.
Why Are Penny Stocks Dangerous?
From large ask/bid spreads (the difference in selling price and buying price) to illiquidity (the inability to turn assets into cash quickly enough to cover obligations) that can make it difficult to enter or exit a position, penny stocks are fraught with dangers that even the most experienced investors avoid. It is important that you understand some of the biggest risks, should you be looking to venture into penny stock investing.
At the very least, understand that buying these securities has more in common with playing slot machines in Las Vegas than it does a disciplined investment program. On average, you are more likely to lose significant amounts of money than you are to make any.
What Penny Stocks Are
The phrase "penny stock" is used to describe shares of a company that trades for very low amounts—typically, between $0.01 and $2.00, though there are no specific rules. Some institutions consider penny stocks as any instrument that trades for less than $5.00 per share.
Companies offering penny stocks often have very small market capitalizations, little to no profits, and minimal operations. They almost always trade on the pink sheets (over-the-counter and not listed on major exchanges) markets because no respectable stock exchange will permit them to be listed.
Under rare circumstances, former blue-chip giants can fall from their lofty heights, becoming penny stocks. The last time this happened on a widespread scale was during the Great Recession of 2008-2009 when many financial institutions and investment banks went broke after being over-leveraged (too much debt to finance operations). Those that didn't go bankrupt but still wanted to retain some semblance of respectability were forced to undergo reverse stock splits (consolidation of stocks) to keep their share prices above the penny stock thresholds.
Why People Are Drawn to Investing in Penny Stocks
The reason most people seem to be drawn to investing in penny stocks is that these companies fluctuate wildly in very short periods of time. In a single week, shares might go from $0.25 to $1.50. The naïve investor thinks, "Wow! If I had put $10,000 in that, I would have been able to turn it into $60,000 almost instantly!" It's an illusion, make no mistake about it.
Unlike giant blue-chip stocks, which enjoy deep liquidity, some of these companies might not have any buyers or sellers for days at a time. If you were to build a position at $0.25, then go to sell it at $1.50 when that price showed up on your brokerage statement, there might not be any buyers.
You could put in a sell order, and it would just sit there, day after day, doing nothing. To illustrate this point, here's a penny stock to use as a real-world example. Here is the relevant data:
- Current market price: $0.18 per share
- Bid: N/A
- Ask: N/A
- Day's Range: $0.15–$0.18 per share
- 52 Week Range: $0.04–$0.22 per share
- Average Volume (3 months): 5,989 shares per day
- Market Capitalization: $1.5 million
If you bought the shares at $0.15 this morning, then tried to sell them at $0.18 this afternoon, you probably couldn't have done it. The actual value of the total amount of shares trading hands each day ranges on average from $239.56 to $1,317.58.
Problems With Penny Stocks
If you showed up with $5,000 or $10,000, you couldn't get your order filled without offering a price substantially above the current market because there aren't that many sellers out there waiting to dump their stock. You might have to put in an order at $0.20 or $0.25 to attract their attention.
The opposite is true if you were a seller. If you had built up a position worth $10,000, you'd have to spend many days selling a tiny bit at a time unless you wanted to drive the price down substantially. Otherwise, you could put the entire block on the market for a much lower price—such as dropping it to $0.12 per share—then hope someone stepped in and bought it from you.
On top of this, if you purposely attempted to influence the share price by placing orders in an abusive way, you are very quickly going to be caught by the Securities and Exchange Commission, and face large fines that more than offset any potential gains you might eke out of the process.
There Is Simply No Need to Trade Penny Stocks
The reality of the situation is that there is no intelligent reason an investor needs to trade penny stocks or hold them in any type of portfolio. The risks are simply too great to offset any perceived benefits. While it may seem boring, a diversified, low-cost index fund is a superior choice for many new investors.