What is a penny stock?

If you’ve ever watched the movie ‘The Wolf of Wall Street’ you might be familiar with penny stocks. ‘Pink sheets’ and ‘penny stocks’ were how Jordan Belfort notoriously made millions. Don’t get me wrong, he never bought any penny stocks. All he did was sell penny stocks, that were worth nothing, to investors for huge prices and make money through commissions. Let’s start with what penny stocks are.

Penny stocks are stocks that trade for, if not a penny, a small amount. Generally, they are considered as any stock that trades under $1 a share. However, according to the Securities and Exchange Commission (SEC), penny stocks are stocks that trade under $5 per share. While some penny stocks are traded on stock exchanges like NYSE (New York Stock Exchange), penny stocks are more often traded on the over-the-counter (OTC) markets. Generally, penny stocks are shares of smaller and relatively new companies. Penny stocks are less liquid in nature, which means they are not bought and sold frequently. OTC markets group that frequently trade penny stocks include OTCQX, OTCQB, and OTC Pink.

What is the difference between a penny stock and a small-cap stock?

To understand the difference between a penny stock and a small-cap stock, let’s look at how they are defined. While a penny stock is defined on the basis of its share price, a small-cap stock is defined on the basis of its market capitalization (used to represent the value of the company). Smallcap stocks are companies with a market cap between $250 million and $2 billion.

Both penny stocks and small caps have small market caps, however, penny stocks are mostly traded on over-the-counter markets such as OTC Bulletin Board, whereas small-cap stocks are traded on major market exchanges like NYSE and NASDAQ. Even though there are stocks trading on NYSE and NASDAQ with share prices lower than $5, they aren’t generally considered penny stocks.

Why should you stay away from penny stocks?

Penny stocks attract a lot of investors mainly because they are cheap. A lower share price means investors can buy a lot of shares for less money. Investors, especially novice investors look at penny stocks as means to make a lot of money with a small initial investment. However, most fail to understand the risks associated with investing in a penny stock company. Let’s look at some reasons why investors shouldn’t buy penny stocks.

Low liquidity

The liquidity of an asset or an item is the ease by which an item can be converted into cash. The more liquid an asset is, the more easily it can be converted into ready cash.

Stock shares of large companies have high liquidity, meaning you can buy and sell them easily, at any time. However, penny stocks have very low liquidity. Primarily because they are traded infrequently, and the trading volumes are low. Once you acquire some penny stocks, you might not be able to sell them at your price or time, due to the low liquidity. You might have to lower your ask price until a buyer is interested in buying at that price. More often that leads to huge losses if you’re selling off large positions. This is even worse when the price is low. It’s highly likely that you will end with a whole junk of worthless stocks. Low liquidity will also result in a high bid-ask spread (the difference between the prices quoted for an immediate sale and an immediate purchase), which will result in a higher transaction cost.

Lack of information

Company valuation is a major part of investing. An investor can make better decisions through due diligence when they have the financial and corporate performance reports on companies, readily available. However, this is not always the case with penny stocks.

Since penny stocks are traded on OTC markets, very little information is available about the penny stock companies. Because, unlike a stock exchange, there aren’t many regulations for a company in the OTC markets. So, OTC penny stocks are not obliged to make their financials and other information regarding the company available to the public. And as most of these companies are new and obscure, it can be very difficult to find reliable information on them. A company might be facing bankruptcy, and you might not know. When there isn’t information available on the companies, the share price becomes speculative, which exposes investors to a lot of scams.

Scams and frauds

The stock market is no stranger to scams and frauds. Over the years, the market has had its share of scams. Investors lost millions over the years through various scams involving shell companies, accounting frauds, Ponzi schemes, and penny stocks.

That’s right! Penny stocks are infamous for scams and frauds. The primary reason fraudsters love penny stocks is their lack of transparency. As I have mentioned before, listing requirements on OTC markets, where penny stocks are traded, are minimum or more often, none. That makes it easier for scammers to manipulate investors, especially inexperienced penny stock investors. One of the most common schemes is the ‘pump and dump’ strategy. Scammers will buy thousands of shares of a rather unknown stock, and they create hype around the stock with false and misleading information to attract investors. You might have come across emails with titles like “HOT PENNY STOCK TO BUY NOW!!!” or “YOU MISSED THE 1000x UPSIDE”, which are mostly these scammers. Once they manage to convince the investors that these are stocks with high ‘potential’, investors will start buying the stocks, resulting in an increase in the stock price. Once the price is high, the scammers will sell off all their shares, earning huge profits, resulting in the steep decline of the stock price. By the time investors realize the truth, scammers would have made a whole lot of money, and investors would be left holding a whole lot of worthless stocks.

Penny stock scams usually involve shell companies, which are legally incorporated but do not have any business operations or assets. De Maison’s scam was a classic pump and dump scheme involving shell companies.

High volatility and risk

The stock market is volatile in nature. The stock prices will move constantly in upward and downward directions in the short term. In the long run, the market generally seems to move in an upward direction.

When it comes to penny stocks, the primary reason most investors choose them as an investment option is the potential upside in the stock price. For example, a penny stock trading at $.0001, and if somebody buys 100 million shares ($10k) and the stock goes up to .0010 they’ll have $100k in profits. It doesn’t always work like that. If it is the other way around, say the stock trades at $.0010 and somebody invests $10k (10 million shares), and the price goes down to $.0001, their investment will only be worth $1000.

Although the risk is inherent with any stock, this highly volatile nature of penny stocks increases the risk exponentially. In fact, the SEC warns investors that if they invest in penny stocks, they “should be prepared for the possibility that they may lose their whole investment”. Also, following the Exchange Act rules of §240.15g-2, the brokers must provide the customer with a standardized disclosure document when an investor wants to buy penny stocks. This document explains the risks associated with buying penny stocks, customer rights, and remedies in cases of fraud.

What should you choose instead of penny stocks?

Investing in penny stocks involves significant risk, exposure to scams, and most importantly, loss of money. Day traders try to capitalize on penny stocks, and they fail more often than not. In fact, only 3.5% to 4.5% of day traders are successful in producing consistent profits for at least several years. For long-term investors, it’s better to stay away from penny stocks, as it can affect your capital gains significantly.

Alternatively, there are other investment options you can choose from. That includes low-cost index funds, etc.

Low-cost index funds

Index funds are passively managed funds that track an index. These funds buy shares of all the companies on the index that it tracks, in order to try and mirror the performance of the index. Unlike actively managed funds, where professionals manage the holdings of the fund, index funds are automated to follow shifts in the value of the underlying index.

This passive nature of index funds results in a lower expense ratio, which typically ranges from 0.02% – 0.09%. Fidelity Zero Large Cap Index (FNILX) would be an ideal option as an index fund, since its expense ratio is 0.0%, meaning you don’t need to pay anything to invest in this fund. Index funds can be a great investment option especially if you are a first-time stock buyer. Additionally, most index funds don’t have a minimum initial investment, so you can start with as little as the share price.

Actually, you can invest with less than that, by buying fractional shares.

Buying fractional shares

A fractional share is a portion of an equity and is less than one full share. Many of the major brokerage firms including Charles Schwab, InteractiveBrokers, Fidelity, SoFi, offer the option of buying fractional shares (TD Ameritrade doesn’t offer fractional share purchases, but it does not matter anymore as the broker has now been acquired by Charles Schwab). This allows you to buy stocks with as little as $5 or $10 dollars. This can be done without paying commissions. Besides, you can get your hands on more expensive stocks like Amazon using fractional shares.

Frequently asked Questions

What defines a penny stock?

According to the Securities and Exchange Commission (SEC), penny stocks are stocks that trade under $5 per share. However, penny stocks are generally considered stocks that trade under $1 per share.

Are Penny Stocks dangerous?

Yes, penny stocks can be dangerous for an investor, as they pose a risk of losing all of their money including the principal amount. Even though a certain amount of risk is inherent with any stock, penny stocks possess a significant amount of risk due to their high volatility.

Can you make money in penny stocks?

Buying (investing and trading) penny stocks is more like gambling. Sure, you could win some. But in the long run, you are most likely to lose all your money. If you want consistently build your wealth, it’s better to stay away from penny stocks and focus on value investing.

Has anyone become rich from penny stocks?

Not really. Many investors became millionaires from owning regular stocks, not penny stocks. Warren Buffet, the legendary investor, focused on value investing where he invested in regular stocks and became one of the world’s richest men.

If you would like to get started with value investing, check out our Amazon-bestseller The 8-Step Beginner’s Guide to Value Investing