If you’ve never heard of penny stocks, they’re basically a modern day version of fools gold. On some level fools gold might look like the real thing but sadly, holds little, if any real value. Penny stocks are much the same with within the investing world. Traditionally speaking, a penny stock is a stock that trades under $5 and is most often traded over the counter as opposed to on a major exchange like NYSE and Nasdaq.
There are late night infomercials, books and sites devoted to preaching the supposed ability to get rich quick by investing in penny stocks and the sad fact is that the message preached is one that is largely smoke and mirrors. So, if you’re considering investing in penny stocks or are convinced they’re a good addition to your portfolio consider some of these reasons as to why you’re better off running the other direction.
Cheapness Doesn’t Mean Value
This was a common defense given for buying penny stocks in my former day job. The person I spoke with would invariably argue that since the stock was only $.20 that it meant it was a good value. Their thinking was they could buy more of it and thus hopefully realize a better return.
The fact of the matter is there is a reason why it’s trading at such a low price and will likely only result in heartache at the end of the day.
Penny Stocks Aren’t Regulated
Depending on your political persuasion you may not like regulation. Regulation, some argue, restricts the ability to do what you want to do. Well, regulation in regards to investing in the stock market can be a good thing. Simply put, it’s there to protect us. This is where penny stocks fall short.
In order to be listed on the major exchanges, a company has to meet a number of different standards in order to have the right to be listed. That is not so with penny stocks. In most cases, over the counter (OTCBB) and Pink Sheet exchanges have little in terms of regulation. What that means for you as an investor is that you have little protection when it comes to penny stocks. It means you’re opening yourself up to things like shell companies and fraud. I don’t know about you, but I’d rather put my hard earned money elsewhere.
You Might Not Be Able to Sell it
I always hated helping a client with a penny stock they couldn’t get rid of. It might sound unreasonable or impossible, but I spoke with investors nearly every day who were in that very situation. They might be sitting there with several hundred or several thousand dollars in the given stock and they could do nothing with it. This could be due to a variety of reasons from highly irregular trading to a stock being halted because it was under some sort of investigation.
If you’re like me then you want a portfolio where you can make changes at a moment’s notice, not one where you fear your ability to make changes. Investing in penny stocks is going to leave you much more open to situations just like that.
Not Every Stock Started This Way
A common thought I’d hear in my former day job was that every company has to start somewhere so why not invest in it? I agree that every company has to start somewhere but that should only be taken so far. I’ve not done the research, but I’d be hard pressed to tell you any current S & P 500 stocks that started out as a penny stock. They likely all were the result of an IPO or a spinoff from a highly reputable company. That doesn’t mean they’re without risk, simply that information is available about them and they have been vetted. Penny stocks, on the other hand, are on the other end of that information/vetting spectrum.
It’s Not A Good Way to Start Investing
While all of the above reasons are bad enough to knock out penny stocks from my consideration as something to invest in, the number one reason why penny stocks are a fools errand is the belief they’re a good way to start investing. This was something I saw a lot of in those wanting to invest less than $1,000. They’d say nearly the same thing each time – I don’t have a whole lot to start with and I can get more with my money this way.
As far as I could, I would use this as a teaching opportunity to explain that more isn’t always better when it comes to investing. Instead, investing in a solid index fund is much better in the long run. Yes, there might be a once in a lifetime opportunity with the given penny stock but a portfolio will only suffer if those chances are taken time and again.
That said, the moral of the story is if you’re looking to start investing with little, then open an account with someone like Motif Investing where you can start with as little as $250 and invest in index funds or dividend paying stocks as opposed to chasing the dream of striking it rich with a penny stock.
Do you invest in penny stocks? If so, have you ever had one that you’ve not been able to sell out of? What’s one thing you’d never invest in because of what’s involved with it?
Photo courtesy of: Steven DePolo