Why Penny Stocks Often Aren’t What They First Seem
February 23, 2010 by Aaron Smith | Category: Investing
Penny stocks are typically defined as stocks selling for less than $1 per share on the market. These stocks often trade over the counter or on the pink sheets rather than on a major stock exchange. For many investors there is a large amount of draw toward penny stocks because they are so cheap and the potential is so huge. In fact, stocks like Microsoft and Dell were once penny stocks and many people made a mint by getting into these stocks early on. While the potential gains are huge, the risks are even larger and many investors fail to understand this until it is too late. It’s time to examine penny stocks and find out about how they work and the dangers of penny stocks.
Potential Gains are Astronomical
The average penny stock trades for less than 25 cents per share, which certainly allows an investor to get deeply involved in a stock without putting too much of their money on the line. If the penny stock trades at just 10 cents per share you can own 1,000 shares for just $100. Let’s say you buy that stock for 10 cents a share and it becomes the next hot stock and makes its way up to the major exchanges and a price level of $25 per share. Do the math here and you’ll see a profit of $24,900 would be made on your original investment if you sold at $25.
Huge Gains Are the Exception and not the Norm
If you are going to get into buying penny stocks, you must realize that huge gains are extremely rare. In fact, most people that invest in penny stocks end up losing everything they invest because the company goes out of business. After all, there is a reason these stocks only cost a few cents per share. If you get into penny stocks expecting to become a millionaire, the odds are you will end up sorely disappointed.
No Transparency or Rules
In my opinion, the single biggest problem with investing in penny stocks is that there really are absolutely no rules involved and there is no transparency as far as financial information on the companies. In the end, what you have is pure speculation about the prospects of a company that almost no one knows about. As an investor and portfolio manager, I pride myself in my ability to research companies and get a leg up on other investors, but this is simply not possible in the penny stock world.
Easily Manipulated and Scams are Abound
Since they are thinly traded, and there are no regulations or rules on their markets, penny stocks are the perfect spot for scammers to target. It is simple to manipulate prices in stocks with such a low float and small volume each day. Internet fraud and constant newsletter promising you of the “next big thing” are all over the place. You would be wise to understand that these people who send you messages promising you huge amounts of wealth if you buy a penny stock are only looking out for themselves and in the end you will get hurt because of it.
Bottom Line
Dabbling in penny stocks can be exciting for some people, but it really isn’t an investment per say. Sure the potential is terrific, but the reality is most people come out much worse than they started when they commence buying penny stocks. If you want to speculate on a penny stock here and there feel free to do so, but realize this isn’t a normal investment and the risks associated almost always trump the possible gains.
