The Pitfalls of Penny Stocks

Most financial advisors and long-term investors tend to avoid penny stocks for a reason. These smaller-company stocks traded on the over-the-counter market tend to fluctuate wildly in price and although some report spectacular gains in a matter of a few days (or even hours), don’t be surprised if they disappear altogether.

Generally if a stock is trading as low as pennies to a few dollars it’s in danger of losing its listing with the national securities exchanges such as the New York Stock Exchange, the American Stock Exchange, and the Midwest Stock Exchange. When this happens a company is normally either in very bad financial shape or on the brink of bankruptcy, though sometimes companies issuing penny stocks are simply new to the market. They may not have been in business long enough to establish a proven track record or credible financial history. Another characteristic may be an inexperienced management team. These factors undermine market reception and the ease with which penny stocks can be traded.

Investors should beware that in addition to their volatility, penny stocks are extremely vulnerable to manipulation by promoters who are intent on misleading or defrauding investors. One common scam is the "pump and dump" in which a promoter amasses an inventory of penny stocks. Employing high-pressure sales techniques, they pitch the stocks to clients. In the course of events, the price of the penny stock will rise, possibly to several dollars per share. As long as the promoter continues locating new investors or convinces current clients to increase their holdings, the scam continues and the promoter profits. When the scam has run its course the stock’s price falls dramatically and hapless investors are left holding the bag.

Such scams can be difficult for investors to uncover because unlike exchange-traded stocks, the current price and volume information about most penny stocks isn’t made available to the public. Brokerage firms trading penny stocks usually provide information only about the trades they make themselves. As a result the investor may not know that a better price is available elsewhere, or worse, that there is no other brokerage firm willing to buy or sell these stocks.

There are other risks associated with penny stocks besides just manipulation, and those risks are numerous. Rather than earning their profits through commissions, brokerage firms selling penny stocks generally make money by charging the investor an undisclosed "markup" fee above what they paid for the stock. Although excessive markups are illegal, some firms nevertheless charge markups of 100 percent or more, which is a sure formula for investor failure.

Penny stocks often have a large spread between the price at which the investor can buy and sell the stock. Upon buying the stock the investor may suffer a substantial paper loss on the investment. For example, if a stock has an asking price of 40 cents and a bid price of 20 cents, the investor would suffer an immediate paper loss of 50 percent. The bid price of the stock would have to double for the investor to break even.

Unlike most large well-established companies, many companies that issue penny stocks don’t make quarterly and annual reports available to the public. This lack of information about the company's operating history and financial health increases the risk to the investor. The market price of such stock can be based more on the aggressive marketing of the selling broker (such as in the pump-and-dump scam) than on the real value of the company.

Some penny-stock brokerage firms resist investors' attempts to sell their stocks for cash. The broker might become "unavailable" to an investor who wishes to sell, or the broker might refuse to accept the sell order unless the investor agrees to buy penny stock in another company that the brokerage firm is marketing.

If you do decide to purchase penny stocks, strongly consider limiting any single purchase to no more than 5 percent of your portfolio. That way even if you do take a loss, you probably haven't invested more than your can afford to lose.