Are Penny Stocks a Good Investment?
Everybody likes a bargain, and stocks with low share prices certainly seem like bargains. With some high-priced stocks costing hundreds or even thousands of dollars for a single share, buying penny stocks — stocks with share prices of less than $5 — can be a tempting way to try to grow your money quickly. However, penny stocks generally have a well-deserved reputation for burning investors.
It is possible to achieve strong returns by investing in young companies with small valuations or depressed stock prices, but typically it’s better to invest only in companies that are larger and have less speculative valuations. Any risky stock buys should at least be limited to shares of companies that generate meaningful revenues — or are pursuing clear, realistic paths to growth.
We’ll delve into how to identify cheap stocks, as well as name some individual stock picks that have significant potential. But first, let’s take a closer look at penny stocks and why they have such a poor reputation.
Can you make money on penny stocks?
It is possible to make money with penny stocks. Then again, it’s technically possible to make money with any type of stock. Successful investors usually focus on the potential for their stock picks, regardless of price, to gain value over the long term.
There are plenty of good reasons to invest in small companies. Investors who buy shares in fast-growing companies that are still small capture a lot more share price upside than those who wait to buy stock until the companies have grown into giants.
However, penny stocks are almost never the bargains that they appear to be. Their shares are cheaply priced for good reason. At best, penny stock companies are unproven and small with dubious long-term prospects for success, and, at worst, the penny stocks themselves are vehicles by which con artists take advantage of unsuspecting investors.
Penny stock investors often erroneously think that a low share price indicates that the company has greater potential to grow than those with higher share prices. In reality, the valuation of a company — also known as its market capitalization — is determined by two factors:
- The stock price
- The number of shares outstanding
That second factor is crucial because how many shares to issue is entirely up to the company. One million shares outstanding at $100 per share is worth exactly as much as 100 million shares outstanding at $1 per share. Moreover, a company with a $100 share price very likely has much stronger growth potential than a company with a $1 share price.
Regulatory authorities know that penny stocks are highly tempting to many investors, so they’re quite explicit about listing their dangers. As the U.S. Securities and Exchange Commission states, That’s technically possible with any stock investment, but the total loss of value is far more likely with penny stocks.
Risks of trading penny stocks
Penny stocks come with substantial risks compared to those of ordinary stocks. The risks include the following:
1. Penny stock companies are tiny. Most publicly traded companies are large businesses that clearly demonstrate their value, which typically ranges from hundreds of millions of dollars to $1 trillion or more. By contrast, the companies that issue penny stocks are generally tiny, with even the largest penny stock company typically valued at well below $100 million.
2. Penny stock companies are unproven. It’s rare for companies that you’ve already encountered in your daily life to be among the ranks of penny stocks. Rather, penny stocks are usually those of less established companies that have yet to prove that they can endure and succeed.
3. Penny stocks don’t trade on major stock exchanges. Penny stocks are not listed by the New York Stock Exchange (NYSE) or the Nasdaq Stock Market (NASDAQINDEX:^IXIC). Instead, penny stocks typically trade over the counter, or OTC. The companies whose stocks trade in the OTC market are subject to less rigorous reporting requirements than those included in the NYSE and Nasdaq. Efficiently buying and selling shares of penny stocks can also be comparatively difficult because stocks that are less frequently traded are more illiquid, meaning that wide ranges between bid and ask prices are common.
4. Penny stocks are sometimes the targets of pump-and-dump schemes. Con artists often target penny stock investors by promoting a penny stock company as the next hot investment. Building hype about a penny stock can pump up its share price, and the price increase itself can be misleadingly cited as evidence of the company’s success. After the stock price increases, the scammers typically sell (dump) their shares for profit and stop promoting the stock. The share price then usually declines, causing large losses for the late-arriving investors who believed the hype.