If only the secret to getting rich was to buy penny stocks. That would be a lot easier than working hard and maximizing your savings.
So what are penny stocks, and why do people invest in them? We’ll explain what a penny stock is, why the “get rich quick” logic is flawed, and break down all of the risks that come with penny stocks.
What is a Penny Stock?
Penny stocks trade at a low price, and typically cost less than $1 per share. They don’t trade on reputable stock exchanges, such as the New York Stock Exchange or Nasdaq.
Instead, they typically trade over-the-counter through the OTC Bulletin Board and pink sheets.
Why Do People Invest in Penny Stocks?
The logic for investing in penny stocks is simple. Suppose you invest $5,000 in Penny, Inc, a stock that costs 5 cents per share. This will give you 100,000 shares of Penny, Inc.
Now imagine that Penny, Inc goes up by just one cent. That one penny increase is a 20% gain, and your $5k investment is now worth $6k!
What if the stock went up by one dollar instead of one penny? That $5k investment would then be worth $105k! All the stock needs is a small increase, and you’ll make a fortune!
Why Penny Stocks Make No Sense
Now that you know why people invest in penny stocks, let me explain why you should never invest in them.
First of all, it makes no difference how much a stock costs per share. What actually matters is the value of the company you’re investing in.
Apple, for example, has a market capitalization of roughly $900 billion. They have around 4.7 billion shares, meaning each stock costs roughly $190 per share.
Apple could become a penny stock tomorrow if they split their stock one thousand times. With 4.7 trillion shares outstanding instead of 4.7 billion, each share of Apple costs 19 cents instead of $190.
Regardless of how you slice Apple, the company still has the same value. Same thing for a pizza. No matter whether a large pizza is cut into 8 slices or 16 slices, you still end up with a large pizza.
What Makes Penny Stocks So Risky?
If it doesn’t matter how much a share of stock costs, then why should you avoid penny stocks? Why not just focus on the value of the company?
Because a penny stock is more than just the price per share. Penny stocks also trade outside of reputable exchanges like the New York Stock Exchange and Nasdaq. Since penny stocks aren’t in reputable exchanges, you’re facing a lot of risk.
Lack of Public Information
Penny stocks aren’t listed on major exchanges, which means they don’t need to post financial statements like their counterparts. Even if they do share financials, they won’t be scrutinized nearly as much as their counterparts in reputable exchanges.
Without financial statements and market scrutiny, it’s impossible to make an educated guess on a penny stock’s true valuation.
No Minimum Standards
Major exchanges like the NYSE or Nasdaq have minimum requirements that must be met to stay on their exchange. Some requirements include stock price, number of shares, total market value, and number of shareholders.
All of the requirements are put in place to protect you as an investor. Investing outside of these exchanges opens you up to these risks.
Liquidity
Penny stocks typically have fewer shares in the market, which makes it easier for owners to manipulate the price.
This is a common strategy called the “pump and dump”. Investors will heavily promote a stock by sharing false or misleading news. Once the stock price climbs, they’ll dump it, and profit on the difference.
Once they profit on the difference, you will end up holding the bag with a loss.
Lack of History
Many penny stocks are fairly new, so there is no history about the company or the executives.
Do the executives put their shareholders first, or themselves? How has the company performed in the past? This is very tough to tell with penny stocks, and that uncertainty leads to investment risk.
Why You Should Avoid Penny Stocks – The Bottom Line
Penny stocks sound great in theory, you can buy a ton of shares with hardly any money. If those shares go up just a dollar or two, you hit the jackpot.
The problem is, it isn’t that easy. Companies go up by their value, regardless of what the stock price is. Your investing goal should be to buy companies that are more valuable than their price, and that can be found with any type of stock.
Unfortunately, penny stocks don’t have to follow the same regulatory requirements as companies that trade on legitimate exchanges. Therefore, you have to find the true value of penny stocks, without having enough information to know what the company is worth!
Check out our post on valuing stocks. Focus on companies that trade on legitimate exchanges, and find those diamonds in the rough.
In the meantime, I’ll leave you with this thought experiment. If penny stocks can make you rich, why are there no billionaires who became rich from trading them?