We examine some of the reasons penny stocks are a high risk, high reward investment, as well as point out a few things investors should be mindful of.
We live in a fast paced world where money is a necessity and earning money fast is a desire. This desire to make wealth as quickly as possible can lead to numerous mistakes and lead to financial losses. When examining the stock market, penny stocks are some of the riskiest investment opportunities, however, they do offer some of the highest payouts and gains rather rapidly, which feeds our desire for quick, “easy money”. There are likely few to no investment consultants that would recommend these high risk, albeit high reward stocks, thus we will go through some of the reasons why these stocks can be problematic to investors.
What Are Penny Stocks?
Penny stocks are stocks that are traded for less than a dollar (as you might imagine), however, the broader view is stocks less than five dollars for each share. The typical penny stock company has a short operating history, a holding company, and only have a few million dollars in net tangible assets. Most have low market caps, low liquidity and are often traded on over-the-counter exchanges (OTCQB, OTCQX & Pinksheets).
What Makes Penny Stocks So Risky?
The high risk involved in penny stocks, compared to stocks on the NYSE or Nasdaq, has to do with limited transparency, information available on the business model, and are often targeted by stock promoters and manipulators. In addition to these factors, the trading market for these stocks is very much illiquid, thus it may require some patience to buy or sell the stock, which can lead to costs associated with having to settle at a value that is less than you wanted.
The fact that many of these stocks are illiquid, shows that investors have trouble obtaining the required due diligence to invest in these companies. It also points to possible negative histories. In order to raise money when starting out or coming out of financial distress, these companies have to sell stock at the price the market will take, which often leads to large amounts of dilution. Due to the lack of information available, and limited transparency, an investor might not know the company is in financial distress, which often leads to making a bad investment leading to personal financial losses.
For larger public companies, there is tons of information available for investors to make decisions. The information is usually easily accessible online by browsing analyst reports, SEC filings, and press releases. However, the over-the-counter exchanges do not really require public reports to remain an active publicly traded company (e.g. Pinksheets). Without such valuable information, it would be very difficult on the investor’s part to make the right and objective trade decisions, and this could often lead to unwise guessing.
Market Manipulation & Scams
Most investors have watched movies about boiler rooms and have seen stock promoters in action after receiving unsolicited emails or telephone calls. The stocks are often promoted as the next best thing or next best success story. The stocks are often compared to large-cap public companies showing the tremendous growth potential and possibilities. The excitement often leads to the investor buying shares of that stock while the company, a third-party, or the promoters themselves dilute the stock, driving the price down.
For the most part, if a company is successful, they likely started out as a private company, then went public, so be sure to research the companies history and avoid blindly taking the stock promoters word. These scammers do not simply limit their outreach to emails and telephone calls, they use financial message boards like Investors Hub and Yahoo! Finance to scam new investors coming to those message boards seeking information. And so, if you are new to the whole stock exchange market, make sure that you decide wisely on which type of stocks to invest and do not go after what may seem easy to get you rich.
Keep in mind that, although penny stocks may be alluring, they may involve huge risks on your part.
Do you trade penny stocks? What are some things you look out for to avoid becoming the next victim of a penny stock scam?