Why I Don’t Invest in Penny Stocks
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We’ve all seen the ads that promise returns of 100-1000% or claim that buying penny stocks will make you rich. My principle regarding investing ads is simple – if it sounds too good to be true, it is. While no one expects to lose money on an investment, we all need to be realistic.
Unfortunately many of these ads prey on our naivety and make us think our pot of gold is just around the corner through their penny stock. There are varying definitions of what a penny stock is, but what I am focused on here are stocks not listed on any major exchange and under $1.
Information is King
Whenever I am ready to make a major purchase, I look for as much information as possible. I research, looking for what best fits my needs and then use that information to make my decision. I do not take this research lightly as I am looking to part with a large sum of cash and want to make a wise decision. I use this same mentality investing in the stock market.
I am a self-directed investor and when considering a stock purchase I spend considerable time (probably too much if you ask my wife) amassing any information I can find. Publicly-traded companies are required to publish loads of information, so it’s easy to come by.
These requirements are non-existent for companies not listed on any of the major exchanges (such as those issuing penny stocks) and thus make it more difficult to come to a well-informed decision. I like to use screeners, like those available through brokerages like Vanguard to help me make my investing decisions as they take a lot of this information and pare it down to justifiable options for me.
High Risk With Little Reward
We all have varying degrees of risk aversion. I tend to be on the risk-seeking end as I am willing to give up some risk to get the possibility of reward. The problem with many penny stocks is that there is very little upside potential.
Sure, if you go from a share price of $.005 to $.01 you have doubled your money, but the reverse is also true.
You Can Lose Your Shirt
In theory any stock can go to $0 at any time. That is a risk we all assume when we put our money into the stock market. However, the risk is heightened when you go into penny stocks. Many times these stocks are near bankruptcy or have some other significant issue going on.
This can make it extremely difficult to control losses or even get out of your investment if the company is going belly up.
Cheap Does Not Mean Good
My Dad had a saying growing up “Look for quality, not quantity.” This saying can easily be applied to investing when making a stock purchase. Would I rather buy 100,000 shares of a stock trading at $.01, or 100 shares of a stock trading $10?
I am going to take the second option every time. Just because you can buy more does not mean it’s better.
Penny Stocks Can Be Hard to Sell
An inherent risk with penny stocks is that it can be difficult to get rid of them. Sporadic and irregular trading activity can cause you to lower your selling price to detrimental levels. As an aside, this can also breed manipulation of the price by some.
If it’s Too Good to be True, Then It’s Too Good to be True
Some promoters of penny stocks claim to peddle the next Google or Microsoft. Would I love to get it on a stock like that, sure I would! But, those stocks did not start out as penny stocks; they started on a major exchange. The rule of thumb to stick to is that if it sounds too good to be true, then it’s too good to be true.
This is not meant to say that it’s impossible to find success in penny stock investing, as it has happened. The problem is that the likelihood of finding success is so minimal that it’s not worth the risk. If you do choose to invest in penny stocks, please make sure and do your homework (as you would with any investment) before putting your hard earned money into it.
What questions do you have about penny stocks?
John is the founder of Frugal Rules, a dad, husband and veteran of the financial services industry whose writing has been featured in Forbes, CNBC, Yahoo Finance and more.
Passionate about helping people learn from his mistakes, John shares financial tools and tips to help you enjoy the freedom that comes from living frugally. One of his favorite tools is Personal Capital , which he used to plan for retirement and keep track of his finances in less than 15 minutes each month.
Another one of John's passions is helping people save $80 per month by axing their expensive cable subscriptions and replacing them with more affordable ones, like Hulu with Live TV.
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