The Pros and Cons of Penny Stocks

Pennies with calculator and magnifying glass representing penny stocks
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There are two sides to penny stock investing, and they couldn't be more opposite. The spectrum ranges from instant wealth, massive profits, and 20-year-old millionaires, to lost savings, scams, illegal activities, and bankrupt companies. The truth falls between these extremes. Investors must fully understand the potentials and risks before they dive into the penny stock pool.

Penny Stocks: The Fairy Tale

Are penny stocks terrible risks, full of nonsense investments and scam artists in fancy cars? The answer is "Yes". Or are penny stocks diamonds in the rough? Are they small companies just getting started, that may have been overlooked or ​undervalued by investors, who can grow a small amount of money to a huge figure in a short time frame? Again, the answer is "Yes".

You may have heard about old widows being swindled out of their savings. Perhaps you knew of someone (who may have been you) buying some risky stock because the story was compelling, but now the shares are worthless. 

Movies like The Wolf of Wall Street and Boiler Room send out the wrong message, touting a thrilling lifestyle of profits at the expense of others. More aptly, this is called "lying and stealing."

But there are two sides to any story. You may have heard tales of some lone penny stock which is now trading over $10 per share

After all, many of America's great companies started small, and the people who saw promise early on became wealthy. Maybe it was all the tales of quick riches which caught your eye, or maybe it was the photos of fancy cars and big houses. 

Despite all the risks, the promise of rewards seems to be more than enough to attract tens of millions of hopeful investors to these low-priced shares (for better or worse). Either way, it is crucial to know the pros and cons of penny stocks.

Pros of Penny Stocks
  • Todays penny stocks are tomorrow's big winners

  • There's a thrill to the chase

  • Shares are kind to your budget

  • Gains can be rapid

  • DIY

Cons of Penny Stocks
  • Companies lack track records

  • More losses than gains

  • Brokers are wary

  • Low trading volume

  • Risky markets

  • Lots of volatility and changes in value

  • Prone to scams

Pros of Penny Stocks

The Big Winners of Tomorrow

There are many good companies trading for pennies. They may have proven leaders and teams, solid financial positions and ratios on the up, a growing market share, and creative products or services that are set to take over an industry.

The Thrill of the Chase

If you have ever made 5% on an investment in a year, you know the thrill that comes with the big gains (and losses) among penny stocks. It's not for the faint of heart, but for those who like to gamble, penny stocks can feel like a joyride.

Turning a Tiny Budget Into Much More

Most penny stock investors have small amounts with which to start trading. If a person has $500 to trade, they may only buy three or four shares of a bigger company but when this same amount of money could purchase thousands of shares of the penny stocks, why not get more bang for your buck?

The Rapid Speed of Gains

Not all penny stocks see quick action in their market price, but those that do tend to make their big price moves within days, not years.

There are many ways to trade penny stocks, and trading at low prices can be good practice if you're just starting out. Mobile apps of this sort have seen a boon in recent years.

Cons of Penny Stocks

Low Quality Stocks

Most penny stocks come from low quality companies. In some cases, this is because their finances and balance sheet are a train wreck, and their operations produce large losses. The product or service they offer could be in a dying industry, or it could be flooded with too many competitors. 

Major Losses

It's a sad truth, but most investors who "take a crack" at the penny stock game walk away with less money than they had in the first place.

Risky Markets

Some penny stocks trade on the New York Stock Exchange, the American Stock Exchange, and the NASDAQ, which means all the underlying companies have rules for how stocks are listed and reported, and investors are held to certain standards. But most low-priced shares trade on the Pink Sheets, OTC, or OTCQX, where there is very little in the way of listing fees, reporting rules, or other standards of trading. Such loose marketplaces are not even stock exchanges, and they attract low quality companies by the thousands.

Shocking Valuations

We have seen wild valuations with any penny stock that is in the public eye, mentioned on the media, or swirling around the rumor mill. It does not take much buying to push the prices of penny stocks higher, so any investor stampede can put the shares to insane price levels. We have seen this with Bitcoin, Marijuana Penny Stocks, Dot Com Stocks, and even Dutch Tulip Bulbs! 

Car maker Tesla once bought a company with a common name, and people piled money into a penny stock that had a very similar sounding name. This mistake drove the value of the worthless shares 10,000% higher before the penny stock crashed back down.

Stock Broker Treatment

Many brokers will charge higher rates for trading penny stocks, and many don't even allow it at all. Most will not accept custom trading orders, such as stop-losses.

Thinly Traded

Unlike larger companies that may trade tens of millions of shares each day, some penny stocks are very thinly traded. Many see only a couple thousand shares exchanged daily, while others may see even less trading volume.

Volatility

Rapid and hefty price moves are great when they go in your favor, but there are two sides to the volatility coin. When prices fall, so does your investment.

Lies, Scams, and Pump and Dumps

The low-priced, thinly traded nature of penny stocks makes them the perfect tool for tricking investors out of their money. With the worst pump and dump scams, the promoter loads up on shares at fractions of a penny, then "puts lipstick on a pig," by casting bed bets in the best light. At the very worst, they may even feed people blatant lies. Their glossy mail-out looks legit, their website seems fancy, and the story they are telling you makes sense. Then they sell as their "victims" buy and push the price higher. The promoter makes money, while those who bought in to the scam will lose.

With so many pros and cons, investing in penny stocks truly needs to be a personal choice. These smaller investments are not for everyone.