The investing industry is one that is plagued with a history of deceit. Fortunately for the average investor, the Securities and Exchange Commission is there to protect us from these deceitful companies. Public companies that you can invest in are required to report important documents of information to the SEC so that this information is public and there is transparency in the market. Without this requirement, public companies could claim they have high revenues when they don’t, and anyone invested in that deceitful company would find their stock worth nothing when it became known that the company is just a shell, producing little to no revenue. If this sounds scary to you, then this is exactly what you’re getting when you invest in penny stocks!
Penny stocks exist on a different market exchange that is mostly unregulated by the Securities and Exchange Commission (Known as the OTCBB and Pink Sheets). The chances of finding a legitimate penny stock are very low. Most penny stocks are simply shell companies, that go through cycles of momentum and stock price because of the individuals who trade them. One day a penny stock can be up 300%, then the next day it can be down 90%, yet literally nothing at all has occurred in the company. Here are the reasons to stay away from the Penny Stocks:
Low Liquidity, High Risk
Unlike the stocks listed in major exchanges such as the S&P 500, penny stocks have very low daily volume. What this means is that you can buy shares of a penny stock, and in some cases have no one to sell it to! On average, penny stocks have volume equivalent to a few thousand dollars being exchanged every day. You want and sometimes need good liquidity in a stock so you can make a quick entry and exit, especially in penny stocks where the stock price can tank on a whim.
Pump and Dumpers
If you ever receive an email or possibly an advertisement that claims you need to immediately “invest” in a penny stock, you’ve been a target of pumping and dumping. The idea behind this is to create unfounded hype for a penny stock the pumper already owns, then as his victims buy into his hype and drive up the price of the stock significantly, the pumper sells his shares for a large profit. Meanwhile, those that bought into the hype will quickly lose their money as the upward stock momentum drops and the stock price heads south.
Inability to do Homework
Penny stocks differ from the stocks on major exchanges in that they have little to no following at all. You almost never find a penny stock being talked about by the financial media. There is usually no analyst opinions on penny stocks, which should put up an immediate red flag. If this company were actually worth something, wouldn’t analysts be interested in it?
Enjoy the Ride
Penny stocks are known for their wild and violent swings in momentum. You could walk away from your trading station/computer for an hour and come back and realize your penny stock went up 25%, then plummeted into the red. With penny stocks, you need to spend many hours every day watching your positions, otherwise you risk missing the golden opportunity of profit.
Unfortunately, I know this article probably won’t sway any new investors to avoid penny stocks. The lure of rapid, high percentage gains is too strong for naive investors. But hey, if you end up losing half your portfolio from a penny stock, don’t say I didn’t warn you.