Penny Stocks: Meaning, Risks Involved and Misconceptions

Penny Stocks are one of the most debated topics in the stock market all over the world. There’s a section of investors and traders that believes that the penny stocks are the only way to earn exponential returns on your investment in the stock market. There’s another section of investors and traders that believes penny stocks to be the sure-shot way to burn a hole in your kitty and turn you penniless.

Thanks to the very low prices, every new investor in the stock market is attracted to the penny stocks at least once! And, the bad reputation of penny stocks created by those against it makes these new entrants reconsider their temptation for low-priced stocks. We understand this is a huge dilemma for anybody who is new to the stock market. This is why we are here with this detailed article about penny stocks.

This write-up will help you understand penny stocks, associated risks, and linked opportunities. We won’t dictate you an answer but help you make an informed decision according to your goal and financial position.

What is a Penny Stock?

The concept of penny stocks originated in the USA. It was in the year 1934 that the Securities Exchange Act provided a standard definition for a penny stock. Any stock, according to the definition, need to fulfill two criteria to be called a penny stock –

• Stock must not be listed on any national stock exchanges
• Stock must be trading at or below 5$

The concept of penny stocks is primarily based on share price. However, market capitalization is also a good indicator of a penny stock. Generally, penny stocks are micro-cap i.e. smaller than small-cap companies.

Practically, when we talk about trading or investing in penny stocks we do not strictly adhere to the above-given definition. For practical purposes, very low-priced stocks are vaguely called penny stocks even in countries where the penny is not a currency denomination. So, what we are actually discussing in this article is whether you should run behind very low-priced shares or not.

Risks Involved in Penny Stocks

No one can deny that penny stocks are risky. Even those who support buying penny stocks are aware of the risks involved and they have their own strategy to mitigate risk or logic to undertake risk while putting money in any penny stocks. So, whether you decide to invest in penny stocks or not you should be informed about the risks associated with penny stocks.

1. Lack of Information

Any sound trading or investment decision is based on tangible information about the company and stock one plans to buy. Putting money in certain stocks without having knowledge and information about the company’s financial position and future growth prospects is more like gambling. Finding reliable information about micro-cap companies is really tough. Even in case, you get some information you cannot be very sure about its credibility. So, lack of information makes penny stocks risky.

2. Lack of Safety for Investors

Companies listed on any major or national stock exchanges like Nasdaq, NYSE, LSE, NSE, etc. need to follow some minimum standards. This minimum standard or benchmark provides a safety cushion for investors. A micro-cap company that is not listed on any major stock exchanges is not bound to follow any such minimum standard. This leaves a lot of gaps for scammers to scam out money from retail investors and traders.

3. Lack of Historical Records

Investing and trading is all game of calculating the probability of success of a business or company. Someone putting their hard-earned money in certain stock signifies that the person sees a profitable future for the company. The majority of penny stock companies are either new or without a historical track record. In such a case an investor or trader has no foundation based on which they can visualize a future for the stock in question.

4. Low Trade Volume

Being micro-cap penny stocks have less liquidity. When a stock has less liquidity it is tough to find a buyer when you plan to sell it. Trading in penny stocks is not like trading in other listed stocks with high market capitalization. Like other stocks you cannot sell penny stocks as soon as you hit your target price. You might need to hold that share because you won’t find a suitable buyer who is ready to buy at the price you want to sell it. Low liquidity increases the chance of malpractices like pump and dump thus robbing small investors of their capital.

Misconceptions Luring Newbie Investors towards Penny Stocks

You must know that there are a few misconceptions that attract new investors towards penny stocks. We are listing these misconceptions so that you are not fooled by rosy pictures portrayed by few people to lure you.

1. Every Big Company Started as a Penny Stock in Share Market

Lie. As a newbie, you may get many people who would convince you in favor of penny stocks by claiming that every big multinational company was a penny stock at the beginning. Some will also give you examples of companies like Coca-Cola, Microsoft, Walmart, etc. They would tell you that the price of these stocks used to be less than one dollar and now you can see the growth of these stocks’ prices. Examples like these can convince anybody to try their luck with a few penny stocks.

But, you should be informed that these less-than-a-dollar examples are manipulated figures. What you are shown is actually an adjusted share price that includes every split of shares that happened over time. If you dig a little deeper you’ll find that Coca-Cola was listed in 1919 at USD 40 per share, according to nasdaq.com. Taking into account every split that happened over time, one share of the company in 1919 is now 9216 shares. Manipulators will try to sell you the story that 9216 shares of Coca-Cola could have been bought with just the investment of USD 40. With this manipulation, you will be made to believe that Coca-Cola was a penny stock worth less than a dollar. While the reality is that it was priced at USD 40 per share about a century ago!

Similarly, share trading for Microsoft began at USD 21 and Walmart at USD 16.50 but the adjusted price shows USD 0.08 and USD 0.01 to be their respective costs. And, these two are frequent examples used for proving that every big company started as a penny stock.

We are not saying that a penny stock company cannot grow to become big but you should always be a little more alert while reading such fairy-tale stories. People can skew figures to fit a certain story.

2. The Lesser the Price the Exponential Will be Your Growth

The second tactic that attracts newbies is the explanation of exponential growth opportunities in lower-priced shares. You are told that you can have more number of shares in penny stocks and a slight upward movement can multiply your investment exponentially.

Suppose, we tell you that a certain penny stock is priced at USD 0.10. With just an investment of USD 500, you can own 5000 shares of that company. If this share moves up just by USD 0.05 you’ll get a 50% return and if it just moves by USD 0.10 your investment will be doubled. Just think of it… 100% return on investment! Doesn’t that sound good?

A lot of people get trapped in such dreamy explanations. Though whatever is said is not false but it’s not the complete truth either. Most of the time people explaining this growth probability skip the part that moving down by USD 0.05 is just as probable as the upward movement of USD 0.05. If you can gain 50% quickly you can also lose 50% of your capital within no time. In fact, there’s always a high probability of penny stocks going down. In such a case you may lose your entire investment.

Are Penny Stocks Good for Nothing?

The above explanations we provided might make you think that we are not in favor of buying penny stocks at any cost. That’s not true. Despite being highly risky, penny stocks are not entirely a lost cause. Some of them may actually turn multibagger and give you 100, 300, or 500% return on your investment. But, you should plan things carefully.

Before making a purchase decision for any penny stock you must gauge your risk appetite and collect as much information about the company as you can. Investing Wisely in Penny Stocks.

If you are absolutely sure that you want to test the waters in penny stock trading, let’s give you some tips to make the journey a little safer for you.

1. Decide the amount you are willing to lose

We understand that you want to buy penny stocks to multiply your investment but that rosy dream should not be your anchor. Think clearly and determine your risk appetite. You should only put that much amount in penny stocks that you can lose without getting heartbroken.

2. Do your own research

Collect as much information about the company as you can. Do not rely only on the data provided by the promoters; you must have some credible third-party information. And, never follow any suggestion given by any expert blindly.

One of the common ways of doing a penny stock scam is paying an expert to recommend the stock’s name. When experts recommend certain shares it starts selling like hotcakes and you never know which of these recommendations is going to be the next pump and dump scam. So, do your own research. If you can’t do the research, better stay away from the penny stocks and multibagger temptation.

3. Trade on major stock exchanges

You can find a few penny stocks on major stock exchanges too. Stick to these. Stocks listed on major stock exchanges are a safer bet and less likely to be a dummy companies or a scam. It is because these exchanges have a certain regulatory mechanism to keep the investors safe.

4. Use platforms with low or no commissions

We do not want you to lose more on brokerage fees and commission than you earn through your penny trade. So, be careful in choosing the trading platform. While most stockbrokers are competing to provide services at a cheaper rate, some charge higher commissions if the stock price is lower than a set standard. So, make sure you know the details of the commission you would be paying on your penny stock transactions.

5. Do not be too greedy

Suppose you buy a certain penny stock and got a good return. Kindly withdraw your investment without being too greedy. Penny stocks rarely give good returns in the long term. People who earn through penny stocks take advantage of short-term moves in price. Long-term investment should be done in stocks where you have full confidence in a better and brighter future.

Is There Any Alternative for Penny Stocks?

If you are someone who now thinks that you are not ready to take the risk of investing your hard-earned money in penny stocks, you might like to know if there’s some alternative to penny stocks. A lot of people are attracted to penny stocks because they provide them the opportunity to be an investor with a very little amount of money. But, you don’t want to be an investor just for the sake of being an investor, right?

So, instead of putting your small savings on highly risky penny stocks, you can alternatively go for fractional shares. If you do not have thousands of dollars to buy Google’s shares (GOOGL) you can be its shareholder with buying fraction of a share. You can start owning shares of the giants with secured future growth with the amount you have.