The Risks of Buying Penny Stocks

When it comes to making a risk-free investment, penny stocks surely aren’t on the list. As a whole, penny stocks are largely underperforming companies, most of which started as $10, $20, maybe even $500 companies before their businesses collapsed into the region of less than $5, the amount often considered to be threshold for penny stock companies.

One of the largest risks investors face in buying penny stocks is that they are often illiquid. That is to say that few analysts watch penny stock companies, and even fewer advocate investing in them. In the United States, securities and exchange law prevents mutual funds, which most people own, from even considering a penny stock in their investment portfolio.

Not a single mutual fund can hold a stock worth less than $5 per share, and that means that companies spend a lot of time and energy to ensure that their company stays above $5 per share. Some companies will do what is called a reverse split, where shares are grouped together then counted as one share of stock. A company with a $4.50 share price, for example, could do a 2:1 reverse split and trade the next day for $9 per share, and thus be in the range of mutual fund investors. It is important to remember that reverse stock splits do not mean that investors own any more or any less of the company than before. In fact, they own the exact same amount as a percentage of the company, but less in terms of the actual number of shares.

The second risk in buying penny stocks is that they are often hard to research. Where large capitalization companies like Target, which has many hundreds of large retail stores, have loyal followings, penny stocks simply don’t attract enough investors for there to be a lot of available material. In this regard, investors will have to work harder to obtain key information about a penny stock than they might have to work to obtain the same information for a large capitalization stock.

As a direct result of being illiquid, penny stocks are often the target of bait and switch, “pump and dump” schemes where an investor will market a particular company as a good investment. If that investor is capable of making a decent case for the company, other investors will pile into the shares. Ultimately, the share price heads higher as they are considerably more buyers than sellers, and the original marketer is now able to sell his or her pre-existing shares to those just buying in.

Minimizing penny stock risk
If you’re adamant about going digging through penny stock companies, there are a few rules you should be ready to follow.

  1. Research is everything – Though analysts probably haven’t dissected the company just yet, you can still do it yourself. Quarterly and annual report filings known by their regulatory name “form 10-K’s” are available for any company that trades on any US stock exchange. This information includes the company’s operational information, balance sheet, income report, and includes a few pre-identified risks the company faces.
  2. Opinions don’t matter – There are literally thousands of profiteers out there who sell penny stock newsletter subscriptions for high annual fees. While you may believe this to give you an advantage in beating the average investor, chances are good that several thousand other people will read the newsletter and buy the stock before you get a chance to even review it.
  3. Buy what you know – because penny stocks are inherently illiquid investments, any penny stock you buy should be in a business, industry, or sector where you have ample understanding or experience. All profitable businesses look good on paper, but since illiquid stocks usually mean that there is a net cost of buying and selling in higher bids and lower ask prices, then you should be prepared to hold on for the long haul.

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