Penny Stocks – A Good Investment?

by on August 26, 2011

Are penny stocks a good investment?  I’m sure you’ve seen numerous emails, articles and advertisements promising to get rich by buying penny stocks.  Well, let’s look at the attributes of penny stocks and then decide if it is worthy of inclusion into your investment portfolio.

Low price.  By definition, penny stocks are priced below one dollar.  While this is alone is not a bad thing, it usually means that the penny stock has been delisted from any major exchange and now trades on the pink sheets or over the counter boards.  Many penny stocks can trade for fractions of a penny, which can make it difficult to accumulate a decent amount of stock.  Also, the low price typically indicates that the company has lost most of its value and is now a microcap stock.  In fact, penny stocks are usually companies that have gone bankrupt, out of business, or have done so poorly that they couldn’t keep up their listing on a major exchange.  Also, some penny stocks are reverse mergers, where all of the formerly bankrupt company’s stock is bought and the company then changes its name to the new company.  This is an inexpensive way for a company to go public, however, most reputable companies would not go public this way.

Low volume and lack of interest.  Because of the low price and lack of a major exchange or analyst coverage, there is usually very little interest in penny stocks, and therefore very little trading volume.  This means that even if you wanted to invest a lot of money in the company, it would be difficult because of the lack of trading volume.  The low trading volume also creates bigger price swings when buying or selling penny stocks.

No Wall Street support.  Penny stocks do not have coverage or support from Wall Street.  They do not have research analysts providing insight, commentary and liquidity.  And they do not have investment banks helping them create value for their company.  While this is not necessarily a bad thing in itself, it is one more attribute that makes it hard to find accurate information and opinion about the penny stock company.  In addition, most institutional investors (mutual funds, hedge funds) avoid penny stocks because of the low liquidity and lack of coverage.

High volatility and risk.  Because of the low volume, lack of institutional investors and lack of information, price swings in penny stocks can be very high.  In fact, purchasing a few thousand dollars of a penny stock that is trading at a few cents, could be enough to make the stock price climb by 10-40%!  And when you own a penny stock and want to sell, you may lose any gains you’ve made because of the downward pressure on the stock from selling that many shares.  Another risk is that penny stocks are often forgotten about and the stock can sit for years not trading at all or at prices below a penny, effectively becoming worthless.

Target of speculators and corruption.  If you do a search for “penny stocks” you’ll find many people promoting them as a way to get rich quick.  This is usually nothing more than a scheme known as pump and dump.  Speculators or corrupt investors buy up large shares of a penny stock, sending its price up substantially.  Then they advertise the stock and spread rumors of its great growth prospects.  Some people see the rise in the stock, believe the “story” and buy the stock, sending the price up even higher.  At this point the pumpers are “dumping” their stock at much higher prices and leaving you with the soon to be worthless stock.  Because many of these companies are not regulated by an exchange or by the SEC, this type of corruption and manipulation is very rampant in penny stocks.

Lack of trust.  Because there is very little information available about penny stocks, no research performed, and no institutional investors that believe in these companies, there is a huge lack of trust in these companies.  Add to that the rampant corruption and manipulation by crooked investors and there is a complete lack of trust in these companies.

Conclusion.  Looking at all the attributes we’ve covered above, I would say that penny stocks aren’t an investment at all, but rather a gamble.  And that they deserve no place in your investment portfolio.  With that said, there are always exceptions to any rule and there will always be a penny stock or two that offer great opportunity.  However, unless you really know what you’re doing and do your research properly, you’re chances of losing money are much greater than your chances of getting rich.

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