Penny stocks

Penny stocks are popular among small-scale hobby investors since each share can be purchased for a low price, but before you decide to put your money into penny stocks it’s important to do your homework a realize the risks inherent to penny stock investing. Investors who prefer lower risk should stick to blue chip and dividend stock.

So, exactly what is a penny stock or penny share? There is no legal definition of the term, just colloquial usage. Generally speaking, penny stocks are common shares of no cap or micro cap companies that are traded at low prices. Typically, there will be low market capitalization.

The term penny share comes from the United Kingdom, where one hundred pennies make up one pound sterling. In countries using dollars and cents and instead of pounds and pennies, the terms cent stocks and cent shares are sometimes used as synonyms for penny stocks and penny shares.

Penny stocks and volatility

Generally speaking, penny stocks are renowned for their high volatility, and this can easily become a self-boosting prophecy as their high volatility attracts super short-term investors. Their rapid buys and sells of large amounts of shares increases the volatility, and this attracts even more short-term speculators, and so on.

It is also a well known fact that stock price manipulators are fond of penny stocks. Penny stocks are cheap to buy for the manipulator, and their low price also makes them ideal bait for a manipulator interested in luring in inexperienced investors. With just a small bankroll, a manipulator can carry out a quick pump-and-dump.

5 common misconceptions about penny stocks

Only OTC traded stocks can be penny stocks

While many penny stocks are traded over-the-counter (OTC), there are also plenty of examples of exchange traded stocks that are generally accepted as being penny stocks.

With that said, many penny stocks that are traded OTC would fail to be accepted by a stock exchange since the companies do not fulfill the minimum requirements for listing. This is something that we as investors must take into account when we make investment decisions.

Since penny stocks are so cheap, it will be very easy to sell them if I need the money for something else

This is a common fallacy among small-scale investors, who believe that a low market price means that the shares must be especially easy to sell quickly if need be. In reality, anyone looking for high liquidity is better served by investing in blue chip stocks or similar. Go for an exchange traded stock with a high daily turnover and small bid-ask spreads. Penny stocks are notorious for having low liquidity and large bid-ask spreads, and you may find it very difficult to match with a seller if you need to sell in a hurry and are unwilling to accept a ridiculously low price. This is especially true for OTC traded penny stocks, and doubly so if you have a large amount of stocks to get rid of.

All those huge blue chip companies once started out as tiny penny stock companies

It is a tempting fantasy – that all big corporations started out as penny stock companies and that by investing in penny stocks we are getting in at the ground floor of the next Microsoft, Google or Berkshire Hathaway.

In reality, many big corporations were already large and successful before they went public and this was reflected in their Initial Public Offering (IPO). When Microsoft went public, the shares traded for well over 20 USD per share on the very first day of trading. So, why does the adjusted stock price for Microsoft’s first day of trading say $0.09? Doesn’t this mean that Microsoft was a penny stock company back then, with shares being bought for a less than dime a piece? No, it doesn’t, because we are looking at the adjusted stock price. The adjusted stock price is adjusted for later splits, which is why the dollar value gets so low. No one sold shares in Microsoft for 9 cents a share right after the IPO.

All penny stock companies are newly formed companies

A penny stock company can be a newly formed company, but there are many penny stock companies that aren’t. Quit a few hobby investors erroneously believe that all penny stock companies are young companies that haven’t been traded for long, and that by investing in penny stocks we are helping start-ups to flourish. Just give this newly fledged company some time, and it will turn into a highly profitable company with a soaring share price.

In reality, a penny stock company can just as well be an old company that simply failed to attain any higher share price than this, or a company that was once traded at higher prices but then dropped down to penny share level.

As always, it is important to do your own research before you invest.

Penny stocks are ideal for small investors

Many of the misconceptions above are vigorously perpetuated by ”financial advisors” in their eagerness to encourage novice investors to buy certain penny stocks.

By looking beyond the misconceptions and doing your own research, you can make an informed decision. Is investing in penny stocks a good idea for you right now? Is investing in this specific penny stock company a sound choice?

Sometimes, the answer to both those questions will be yes. Investing in penny stocks isn’ta a surefire way to lose ones money. There are definitely people in this world who make money buying and selling penny stock. However, for a novice investor, penny stocks wouldn’t be my first suggestion, unless the investor is well-informed, actively looking for a high-risk project and willing to roll with the punches.

Many small-scale novice investors are attracted to penny stocks due to the low share price, and the rampant volatility can look appealing if you only look at the upswings. Even with a tiny bankroll like mine, I can make a sizeable profit since the gains are so big  in percentage… However, many of these investors are devastated when they experience violent downswings post-purchase.

Another reason why even even risk-adverse small-scale investors can be attracted to penny stocks is the perceived ability to manage risk by risk-spreading. We are constantly told to ”not put all our eggs in one basket” when investing in stocks. The sensible thing to do, we’re told, is to spread risk by buying stocks in several different companies, in several different sectors, in several different geographical regions, and so on. So, what are we to do when we look at our meager bankroll and realize that it’s hardly large enough for such risk spreading tactics if we invest in shares costing $40 a pop or more? Maybe penny shares is the answer? After all, if we go for penny shares we can afford to buy shares in a multitude of different companies…

Once again, research is the key. Will this risk-spreading negate the increased risk of penny stocks in any tangible way? Is this the the optimal strategy for you, or would you be better served by some other investment strategy, such as putting the money in an index fund?