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7 Reasons Why Most Investors Should Avoid Buying Penny Stocks

In doing their stock market research, many new investors come across ads and articles explaining that low-priced penny stocks representative of new companies are the key to going from rags to riches.

Often driven by a desire to live the life of the actor in the ad — surrounded by beautiful yachts, cars, homes, and people — unsuspecting investors jump in, trying their hands in the incredibly risky penny stock investing space.

Of course, people do make money investing in and trading penny stocks, but as you’ll find, the concept is not a one-size-fits-all map to wealth. In fact, investing in penny stocks is a high-risk endeavor that often leads to significant losses for those who take part in it.

What Are Penny Stocks?

Penny stocks generally represent small companies that trade with a share price of under $5 per share and market capitalizations of under $500 million. The penny stock category also covers micro-cap stocks, which are stocks that trade with market capitalizations under $300 million.

There’s a common misconception that penny stocks are only found on over-the-counter (OTC) markets. These marketplaces include a wide array of OTC exchanges that cover stocks known as pink sheets and bulletin boards that are not listed on the major U.S. stock exchanges. OTC stocks are generally unregulated or underregulated, increasing the risk associated with investing in them.

However, the OTC markets aren’t the only place you’ll find penny stocks. In fact, major stock exchanges like the Nasdaq and the New York Stock Exchange (NYSE) list stocks that by most definitions fall into the penny stock category.

Penny stocks trade with low share prices and low market capitalization because they don’t represent well-established companies. Many penny stocks represent companies that are still in the planning phase and don’t even have a product to show for their work. Those with products either haven’t hit the market or, if they have, they don’t have a proven record of sales and profitability yet.


Why the Average Investor Shouldn’t Invest in Penny Stocks

Penny stocks often represent underdeveloped companies with liquidity and profitability issues, but that’s not the only reason the average investor should steer clear of these stocks. Before diving into the pennies, know that investing in them can expose you to the following risks:

1. Penny Stocks Experience High Levels of Volatility

Those who are successful in the penny stock space make the most of smaller stocks’ volatility. High levels of volatility mean stock prices move rapidly in one direction or another, creating the opportunity for significant short-term gains.

Volatility is a double-edged sword.

Sure, high levels of volatility can result in significant short-term gains, but they can lead to significant short-term losses as well.

It’s all a matter of supply and demand.

Penny stocks usually come with small public floats, meaning that there is a limited number of shares available to the public. The law of supply and demand tells us that when demand is high for shares with a low supply, prices must rise.

At the same time, when demand diminishes — which generally happens quickly in the world of penny stock trading — prices will fall as quickly as they climbed. While it’s great to enjoy the upswing on a low-float penny stock, the downswing is painful and often happens so quickly that significant losses simply can’t be avoided.

2. Penny Stocks Have Generally Unproven Business Models

Even penny stocks with products on the market haven’t proven that they have the ability to sell their products to the masses. These are relatively small companies that are still learning the ropes in their respective industries or working to innovate and build an entirely new market.

Without a proven track record of strong sales, profitability, and consumer adoption of products and services, any suggestion that any of these goals will take place in the future is nothing more than speculation.

Successful investing involves researching the history of the company and gauging its potential for growth. Because penny stocks aren’t blue-chip companies with a long history of growth like Amazon.com, penny stock investors are, at best, making minimally educated guesses that things will go well in the future.

The bottom line is that without an adequate history to dive into when you do your due diligence, there’s no way to determine what the future holds for most penny stocks with any level of accuracy.

Pro tip: Before you add any stocks to your portfolio, make sure you’re choosing the best possible companies. Stock screeners like Trade Ideas can help you narrow down the choices to companies that meet your individual requirements. Learn more about our favorite stock screeners.

3. Manipulation and Scams Are Prevalent Among Penny Stocks

With the United States Securities and Exchange Commission (SEC) overseeing all that is the U.S. stock market, manipulation and scams are not commonly thought about when making investments. Unfortunately, these activities are likely more common than you think.

Moreover, penny stocks are generally the home of these scams.

One of the most common is known as the pump-and-dump scheme. This scam involves an investor or group of investors purchasing a large number of shares in a penny stock. The con-artists then disseminate false information across the Web, in social media, and directly to investor inboxes in an attempt to “pump” the price of the stock up.

Once the stock has been pumped up, the scammers dump their shares on the unsuspecting investors who bought in on false information, taking profit for themselves while leading to significant declines very quickly for those left holding the bag.

4. Paid Promotion Often Skews Information

Penny stock companies don’t generally have a natural following of market analysts. As new companies, most investors don’t even know they exist. While many small companies only engage in informational services when working to get their names out, some of them choose to work with promoters to artificially inflate the price of their shares, often in an attempt to raise cash fast.

These promoters charge tens or even hundreds of thousands of dollars to disseminate information that’s been cherry-picked by the company’s management or written to push investors to dive in quickly by triggering a fear of missing out.

Unfortunately, these promotions rarely last longer than a few days, and once they’re over, excitement about the stock and demand for shares tends to fizzle quickly, leading to significant losses for the unsuspecting penny stock investor.

If you decide you want to get involved in penny stocks, be sure to read disclaimers on every article you read. If you see that a publicly traded company paid $50,000 for promotional services, stay away!

5. Penny Stocks Generally Lack Profitability

New companies aren’t always profitable. In fact, making a profit as a young, budding company is incredibly difficult. For many companies, all money generated from operations goes back into the business to fund further growth.

The vast majority of penny stocks don’t earn a profit. As a result, these companies are highly dependent on the money they have in the bank and the success of their relatively unproven product or service concepts.

Should the well run dry on the company’s balance sheet before it’s able to generate a profit, it may make the decision to issue new shares, selling them on the open market to raise funds.

There’s a major problem for investors with this process. Think of a publicly traded company like a pie, and every share like a piece of that pie. When a company issues new shares, the pie isn’t getting any bigger or smaller — it’s being cut into more pieces. That makes the size, or value, of each piece smaller. In the stock market, these fund raises are known as dilutive offerings because, like cutting extra pieces of a pie, these transactions dilute value.

In some cases, struggling penny stock companies simply couldn’t sell shares if they wanted to. With few options, these companies “explore strategic alternatives” — which is, in most cases, a last-ditch effort to sell assets or the entire company to the highest bidder, hoping for a deal that makes sense for the investors and the corporation. Should an alternative not be found, bankruptcy may result.

Ultimately, where there’s no profit, there’s risk of insolvency, dilution, and even bankruptcy — and for many penny stocks, that potential risk is always just around the corner.

6. Penny Stocks Don’t Always Provide Updated Financial Statements

Any stock listed on major stock exchanges like the Nasdaq and the NYSE is required to share quarterly and annual financial statements, giving investors a detailed look into the financial stability of the company. However, if you’re trading penny stocks in the OTC markets, that’s not always the case.

There are different OTC markets, with the lowest of the low being pink sheets. These stocks are generally underreporting or not providing financial statements to investors at all. You’ll also find many companies not reporting or underreporting their financials on other exchanges.

Without a history of financial reports that give you an understanding of the financial stability and direction of the company, it’s impossible to make an educated decision as to whether the stock is likely to rise or fall in value in the future.

7. It’s Often Difficult to Sell Falling Penny Stocks

When penny stocks fall, they tend to fall quickly. It’s all part of trading in a marketplace riddled with volatility. These stocks fall when investors lose interest because, with relatively few shares available, it doesn’t take many investors to sell to put a serious dent in the company’s value.

The problem is that most penny stocks aren’t popular companies to invest in. So, even though the price may move quickly, there’s only a small group of investors buying and selling the stock. When that group decides to bail, trading volume dries up because nobody wants to buy shares.

If you want to sell but there’s no buyer for the shares you own, well, they’re yours to hold. These types of things happen pretty consistently among penny stocks. If it happens to you, there’s nothing you can do about it but count your losses.


Is it Possible to Successfully Trade Penny Stocks?

There’s no doubt about it — many people have found success picking and trading penny stocks. For that matter, there are also quite a few musicians who have made millions upon millions of dollars from selling their hit songs, and a huge number of professional athletes who will never have to worry about money again. But for every runaway success story, there are countless others who tried their best and fell short of superstardom.

Successful penny stock traders who have gone from rags to riches have a knack for technical analysis, a strong stomach when it comes to risk, and an uncanny ability to see patterns and value where few people think to look.

Sure, you can be successful as a penny stock trader — and the probability of success is better than the probability of becoming a platinum-selling musician — but the fact is that it’s difficult and, for most investors, improbable.


What Alternatives Provide Safer Access to Growth?

Trading penny stocks is all about achieving growth at a rate that’s faster than what the overall market has to provide. However, there are several ways to tap into growth without having to risk your nest egg on a speculative new company in the hopes that a miracle happens. Two of the most common high-growth options include:

Investing in Small-Cap Index Funds

Index funds provide exposure to every stock listed on the underlying index the fund was built around. These funds provide high levels of diversification and access to small-cap companies with compelling growth potential.

Some of the best small-cap index funds on the market today track the Russell 2000 index. The Russell 2000 index tracks the 2,000 companies with the smallest market capitalizations on the Russell 3000 index. Effectively it takes the 3,000 largest companies by market capitalization and excludes the top 1,000, leaving the Russell 2000 index full of quality small- and mid-cap companies.

These stocks are chosen for their high probability of growth and their relatively low market caps. The stocks listed on the index aren’t quite penny stocks but are relatively small and still have quite a bit to prove. Nonetheless, the vast majority of these companies have products on the market and are generating compelling growth.

Although risk in these stocks is still higher than in blue-chip stocks, it is far lower than investing in penny stocks that offer little more than a hope and a dream.

Pro tip: You can earn a free share of stock (up to $200 value) when you open a new trading account from Robinhood. With Robinhood, you can customize your portfolio with stocks and ETFs, plus you can invest in fractional shares.

Follow the Growth Investing Strategy

If you’re not comfortable with risking your money on penny stocks or small-cap stocks but you still want to tap into strong growth, it’s time to look into growth investing.

The growth investing strategy is based on identifying stocks that have found their footing in the market and are taking their audience by storm. Earnings and revenue have seen compelling growth over the past several quarters and all signs suggest that growth will continue for the foreseeable future.

It’s also worth mentioning that one of the wealthiest investors in the world, Warren Buffett, is a growth investor. So there’s plenty of money to be made using the strategy.


Final Word

Penny stocks have made millionaires. Someone is out in the middle of the ocean on a beautiful yacht right now because they made millions trading penny stocks. However, your probability of success as a penny stock investor is much lower than your probability of success investing in index funds or following a strategy like growth investing.

Penny stocks have their place and are a necessary part of the U.S. economy. After all, stock market funding provides the capital that allows the innovation in areas like technology and medicine that made the U.S. what it is today.

Nonetheless, those who invest in and trade penny stocks are often taking on an extreme level of risk. Because advertisements make the process look so simple and profitable, beginners get involved knowing little about the stock market and the risks they’re accepting, often leading to tremendous losses.

If you’re an expert investor with a knack for technical analysis, a strong stomach, and money you’re willing to risk losing, give penny stock trading a shot. If not, it’s best to stay away.

Joshua Rodriguez
Joshua Rodriguez has worked in the finance and investing industry for more than a decade. In 2012, he decided he was ready to break free from the 9 to 5 rat race. By 2013, he became his own boss and hasn’t looked back since. Today, Joshua enjoys sharing his experience and expertise with up and comers to help enrich the financial lives of the masses rather than fuel the ongoing economic divide. When he’s not writing, helping up and comers in the freelance industry, and making his own investments and wise financial decisions, Joshua enjoys spending time with his wife, son, daughter, and eight large breed dogs. See what Joshua is up to by following his Twitter or contact him through his website, CNA Finance.

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