The Pros and Cons of Penny Stocks

The positives and negatives to penny stocks

pros and cons of penny stocks
Pennies with calculator and magnifying glass. Getty Images

There are different 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 investments, scams, illegal activities, and bankrupt companies.  The reality is somewhere in between these extremes.

Are penny stocks risky, terrible investments, full of obliterated investments and scam artists in fancy cars?

  Yes.  

Are penny stocks small companies just getting started, or which have been overlooked or ​undervalued by investors, and can multiply a small investment in a short time frame?  Yes.

You've probably heard about old widows being swindled out of their retirement savings.  Perhaps you knew of someone (which may have been you) buying some risky investment 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, almost encouraging an exciting lifestyle of profits at the expense of others.  More aptly, this is called "lying and stealing."

However, there are two sides to any story.  You've almost certainly seen tales of some penny stock which is now trading over $10 per share. 

After all, many of America's great companies started small, and typically their investors 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)!  However, it is important to know the pros and cons of penny stocks.

Pros of Penny Stocks:

The Big Winners of Tomorrow:  There are many excellent companies trading for pennies.

  They have proven management teams, rock-solid financial positions, growing market share, improving financial ratios, and disruptive products or services that are set to dominate an industry.

Excitement:  For anyone who has made five percent on an investment in a year, they understand the excitement which comes with the big gains and losses among penny stocks.

Turning Small Investments into Much More:  The majority of 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 could purchase thousands of shares of the penny stocks in which they are interested.

Speed:  Not all penny stocks move quickly in price, but the ones which do can typically make their big price moves within days, not years.

Cons of Penny Stocks:

Low Quality Companies:  The majority of penny stocks are low quality companies.  In some cases, this is because their financial position is a train wreck, their balance sheet is frightening, and their operations are producing large losses.  Alternatively, they may have a questionable product in a dying industry with numerous competitors.  According to decades among low-priced shares, my team will tell you that 95% of penny stocks should be considered low quality.

Most Investors Lose Money:  This is an unfortunate truth, but the majority of 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 (including their lower level Bulletin Board market), which means all the underlying companies have listing standards, reporting requirements, and investor communication obligations.  However, the majority of low-priced shares trade on the Pink Sheets, OTC, or OTCQX, where the listing fees, requirements, and reporting regulations are almost non-existent.  These low-caliber marketplaces (technically, these are not even stock exchanges) attract lower quality companies by the thousands.

Shocking Valuations:  We have seen ridiculous valuations with any penny stock that is in the public eye, mentioned on the media, or swirling around the rumour mill.

 It does not take much buying to push the prices of penny stocks higher, so any investor stampede can put the shares to unsustainable price levels.  We have seen this with Bitcoin, Marijuana Penny Stocks, Dot Com Stocks, and even Dutch Tulip Bulbs!  More recently, electric car maker Tesla bought a company, but investors mistakenly piled into a similarly-named penny stock, driving the value of the worthless shares 10,000% higher... before the penny stock crashed back down.

Different Stock Broker Regulations:  Many stock brokers will have higher commission rates for trading penny stocks, if they even allow it at all.  Most will not accept special trading orders, such as stop-losses.

Thinly Traded:  Unlike larger companies which may trade tens of millions of shares each day, some penny stocks are very thinly-traded.  Many see an average of a few thousands shares exchanged daily, while others may see even less trading volume.

Volatility:  Rapid and significant price moves are great when they go in your favour, but there are two sides to the volatility coin.

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," telling the investor community grossly misleading statements at best, or blatant lies at worst.  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 anyone who bought in loses.

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