Should You Invest in Penny Stocks?
Investing In Penny Stocks is Volatile, Speculative and Easily Manipulated
Penny stocks are stocks priced below one dollar. However, there is more to them than just that. They are also high risk stocks that have typically been delisted from a major exchange and have very little interest from stock investors. They are also the number one vehicle of pump and dump schemes used by crooked investors. Let's cover some of the attributes of penny stocks to see if they are worth adding to your portfolio.
Low price. By definition, penny stocks are priced below one dollar. However, many penny stocks trade for only a few cents or even fractions of a penny. The first thing you should ask is why is the stock price so low. Many times penny stocks are companies that have fallen on hard times, whose products have become obsolete, or companies that have actually gone out of business. In other words, there is a reason their stock price is so low. In some cases, a legitimate company will buy all of the shares of a penny stock and then change the name of the company in order to become public (also known as a reverse merger). These companies are sometimes legitimate but you should always question why a company worthy of investment is trading on the penny stock exchanges (OTC).
Low volume. Penny stocks typically do not trade on a major exchange like the nasdaq, but rather on the over the counter market (OTC). Because of this lack of visibility, they typically trade with very low volume. This makes it very difficult for large investors to buy or sell many shares, which often means that the people buying and selling penny stocks are individuals that are speculating rather than investing.
High volatility. As a result of the low price and low volume, penny stocks have very high volatility. For example, if a stock is trading at 10 cents and the bid / ask spread is two cents (i.e. you can buy it for 12 cents and sell it for 10 cents), simply buying or selling a few shares can change the quoted price by as much as 20% (2 cents divided by 10 cents). Moreover, if someone wants to buy a larger number of shares, it could move the stock by a high percentage. That is great if you own it and are watching the price increase, but when you need to sell, you can often drive down the price before you sell all of your shares. This high volatility makes penny stocks a target for speculators, and hence all of the "get rich quick" marketing you see related to this field.
Lack of information. When buying a stock, or any investment for that matter, you should get to know the company you are buying. Analyze business trends, read press releases, look at the background of management, and review audited earnings and financial statements. Doing this for most penny stocks is very difficult. Because they are often in default of audits, use unknown accounting firms, and do not offer full disclosure, it is often nearly impossible to really know if a penny stock is a legitimate company. Many of these companies do not release press releases or give any meaningful updates on their business.
Target of speculation. Because of the high volatility and ease of manipulation due to lack of the exchange requirements, penny stocks are often the target of speculators and crooked promoters. Speculators and gamblers often buy the stocks looking for huge returns and based on false reports provided by pumpers. Pump and dump refers to people, websites and newsletters that buy a penny stock, promote it, then sell when the price goes up. If you want to see lots of examples of this, just type "penny stock picks" into a search engine and look at the sponsored results. You most likely would never hear of a penny stock if it weren't for some type of pumper. And by the time you buy in, you are often just buying the shares that the pumper bought for a fraction of the price you are paying. Soon after these runs, the stock will usually go back to trade near its low.
Lack of interest. Because penny stocks don't trade on an exchange, don't have research analysts covering them, and don't attract large investors, there is often very little interest in the companies and the shares. This leads to all of the attributes listed above.
Lack of trust. Because of the lack of information from management and all of the manipulation that goes on around penny stocks, it is hard to trust these companies. In fact, many are frauds or are being manipulated without managements consent.
Conclusion. I guess it's pretty obvious where we stand on penny stocks. Although there are always exceptions to any rule, we just don't think penny stocks are investments, and don't think that they deserve any place in a well-balanced portfolio. With that said, if you want to take a small amount of your portfolio and speculate/gamble on penny stocks, its probably a better bet than playing the lottery or visiting a casino.
See Also: Beginner Information for Investing