Investing in Penny Stocks Comes with Many Added Risks for Investors

One of the largest barriers to investing in stocks is understanding the many different types and categorizations of these assets. While stocks are essentially a piece of equity in a company, they can have many different features. For example, dividend stocks provide additional income based on company performance.

Another type, penny stocks, are often misunderstood. Despite the name, the SEC classifies penny stocks as any stock that trades for less than $5 per share. Often, penny stocks are shares in companies facing financial difficulty with small market capitalizations. Penny stocks are often not listed on major market exchanges and instead trade through over-the-counter transactions.

The Historical Reputation of Penny Stocks

Because of the nature of penny stocks, they have high volatility. The wild price swings have made them the target of many investors willing to accept high risk for high reward. However, this feature has also made penny stocks prone to fraud. If you have seen movies like Boiler Room or The Wolf of Wall Street, you may already be somewhat familiar with penny stocks, as they are at the heart of the schemes in those movies.

People with bad intentions can use high-pressure sales techniques to exploit investors who are new to the market. These techniques fool investors into purchasing large volumes of penny stocks. Then, the same fraudsters spread disinformation in the market to inflate the price and entice even more investors.

Once the price rises to a high enough level through these tactics, the scammers sell all their shares at the high price, which then collapses the value and renders everyone else’s shares essentially worthless. While it can be hard to separate penny stocks from their reputation, it is important to recognize that not all of them are scams. However, the truth is that relatively few penny stocks offer a real chance at growth, and the majority of them stay at a low price. Some of these stocks will gain value and begin trading on larger exchanges, which is how investors can dramatically increase the value of their portfolios, but choosing the right stocks can prove extremely difficult.

The Risks Involved When Investing in Penny Stocks

Penny stocks generally come with much higher risk than other categories of stock. As mentioned, these stocks have very high price volatility, which relates to the low price. If a stock trading for $1 goes up to $2, that is a gain of 100 percent—even though it does not look like a significant jump. In this situation, investors just doubled their money.

However, the same is true for losses. Because the price is so low, even small losses can mean a significant percentage of the investment is gone. The other problem relates to the companies themselves. Companies with penny stocks generally do not have any kind of proven track record and typically have lower reporting requirements, which makes it nearly impossible to do due diligence. Mainstream stocks provide much more data, whereas penny stocks often involve relatively blind purchases.

Penny stocks also suffer from low trading volume since they are sold outside of the large stock exchanges. Because these stocks have few buyers, they are not as liquid as you might think. If the stock you bought low quadruples in price, that is meaningless without another investor ready to purchase the shares from you. Investors frequently only make profits on paper when it comes to penny stocks. This sort of block can be especially frustrating to someone new to the market and unfamiliar with volume constraints.

The Bottom Line When It Comes to Penny Stocks

Many young investors are attracted to penny stocks because of the price. They think they can purchase a large number of shares and keep their risk low since the price is low. However, penny stocks come with many risks on top of the ones typically associated with this asset class, and losses are felt just as hard when the price of an investment is low. People often end up losing their entire investment when they go with penny stocks.

Investors who have limited amounts of money to spend in the market have several options outside of penny stocks that do not come with the same risks. For example, investors can purchase shares of exchange-traded funds or fractional shares, which essentially break up more expensive shares among several investors. These more traditional investments come with significantly lower risk.

Ultimately, penny stocks are a form of speculation since it is so difficult to get information about the companies issuing them. While some investors with large portfolios may include some penny stocks among their investments, they always accept the risk of losing that part of the portfolio entirely. If you cannot stomach that idea, then consider other investing options.

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