Tens of thousands of smaller-company stocks trade on the over-the-counter (OTC) market, which is opposed to the national securities exchanges such as the New York Stock Exchange, the American Stock Exchange, and the Midwest Stock Exchange. Some of these companies are quite small and sport low prices per share, ranging from pennies to several dollars — hence the name penny stocks.
Most financial advisors and long-term investors tend to avoid penny stocks because of the extremely high risk that comes with owning them. Penny stocks tend to fluctuate wildly in price, and although some report spectacular gains in a matter of a few days or even hours, those who invest in them are generally surprised when they disappear altogether.
Generally, if a stock is trading that low, it is in danger of losing its listing with an exchange. When this happens, a company is normally in very bad financial shape or on the brink of bankruptcy. However, 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.
The Risks are High
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,” where a promoter amasses an inventory of penny stocks. Employing high-pressure sales techniques, the stock is “pitched” 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 locates 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 of most penny stocks isn’t available to the public. Brokerage firms who trade penny stocks usually provide information only about the trades that they make themselves. As a result, the investor may not know whether a better price is available elsewhere or if other brokerage firms aren’t willing to buy or sell these stocks.
There are other risks associated with penny stocks besides instability and manipulation, and those risks are numerous.
Risk of Being Overcharged
Rather than earning their profits through commissions, brokerage firms that sell penny stocks generally make money by charging the investor an undisclosed “mark-up” fee above what they paid for the stock. Although excessive mark-ups are illegal, some firms nevertheless charge mark-ups of 100% or more, which is a sure formula for investor failure.
Risk of Substantial, Immediate Loss
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 ask price of 40 cents and a bid price of 20 cents, the investor would suffer an immediate paper loss of 50%. The bid price of the stock would have to double for the investor to break even.
Lack of Information
Unlike most large, well established companies, many companies that issue penny stock 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.
Inability to Sell Stock and Receive Cash
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.
Because this article is intended for beginning rather than advanced investors, we’ve focused more on the pitfalls of purchasing penny stocks than the potential rewards. If you do decide to purchase them, strongly consider limiting any single purchase to no more than 5% of your portfolio. That way, even if you do take a loss you probably haven’t invested more than your can afford to lose.