While their name may make them sound approachable and cheap—perfect for timid investors—they’re actually considered quite risky investments that may end up costing you way more than just a couple pennies.
What’s a penny stock?
In straightforward terms, a penny stock is a stock that is traded for less than $5 a share (although they started off as being traded for less than a dollar, hence the name). Penny stocks are stock from small companies that aren’t usually listed on major exchanges like the New York Stock Exchange or NASDAQ. The U.S Securities and Exchange Commission refers to penny stocks as “microcap stocks,” meaning that the companies behind them usually have a relatively tiny total market value of less than $300 million.
Penny stocks are considered speculative in nature because of their inherent volatility. They’re also a great opportunity for scammers, who favor penny stocks for schemes charmingly known as “pump and dumps.” The price of a penny stock is artificially inflated and sold to investors at much higher prices than they were actually purchased at, leaving the buyer with a worthless stock and an empty wallet.
“This sounds sketchy. Why would someone want to invest in these?”, you might be wondering. Well, because the prospect of making a boatload of money by finding “the next big thing” is undeniably appealing. Penny stocks have the potential for extraordinarily high returns. There are those insane success stories you’ll hear once in a while, where one person became a millionaire within three years just from trading penny stocks (although we have to stress that that is highly unlikely).
Another problem with penny stocks is that they’re mostly unregulated, since they don’t trade on major exchanges. Instead, they’re traded “over the counter” (OTC), and therefore don’t need to fulfill minimum standards regarding things such as total market value and number of shareholders. These minimum standards are placed upon companies trading on major exchanges in order to protect investors.
But because penny stocks often trade at such low prices, they’re attractive for investors who might want to put $600 toward investments and are looking for the most bang for their buck. That amount of money might only buy them four or five shares of a major company listed on an exchange, but with the same money they could buy hundreds, if not thousands of shares of penny stock. And if the penny stock takes off—which can happen within a matter of days if it does—then the returns on those $600 can be pretty spectacular. But again, with the level of risk you’re taking, you’re essentially gambling with those $600. So make sure those $600 weren’t going to go towards paying off some high-interest credit card debt or any other pretty important expense.
Penny vs. blue chip stock
Penny stocks are classified as “microcap stocks,” which means they’re basically the opposite of blue chip stocks, which are stocks from well-known, established, and exchange-listed companies with a history of steady returns. A blue chip company generally has a market capitalization worth several billion dollars. Because of that, there are some pretty inherent differences between the two:
- Value. Blue chip companies have an established and proven history of value. They tend to be companies that are either household names or market leaders in their field, and therefore have a high probability of stability and are associated with less risk. This also means that they’re not going to generate high annual returns or experience significant changes in price. A penny stock, on the other hand, doesn’t really have a proven history of value yet, and is driven by its perceived potential. Hence the volatility/speculative aspect.
- Risk/reward ratio. Blue chip companies are classic “low risk, low reward” stocks and are a smart way of investing if you’re looking for long-term, stable growth. Penny stocks, on the other hand, are the classic definition of “high risk, potentially high rewards” type of stocks. Emphasis on the word “potentially.” All investing inherently has an aspect of risk to it, but that risk is significantly multiplied when you’re dealing with a stock that’s based on speculation and little regulation.
- Change in prices. It can take years for blue chip stock to change their prices, and even then it’s usually a small change. With penny stocks, on the other hand, prices can yo-yo within days or even hours.
- Access to information. Because blue chip stocks are traded on market exchanges and are often very prominently in the public eye, there’s a great deal of information available about them. You can find their quarterly public earnings reports, past returns and dividend payouts to shareholders, and anything else you might need to get a full picture about what kind of company you’re putting your money in. With penny stocks, none of that is required, and you’ll have to work a lot harder to find any credible information about the company behind that cheap stock.
Should I invest in penny stock?
The unregulated and speculative nature of penny stocks make them pretty risky investments. It’s hard to properly research the company you’re investing in because they’re usually very new and small. While that doesn’t always mean it’s a “bad” company, it does mean that there’s a risk that you’re dealing with a low-quality company—one that might not make it until the end of Q3. Also keep in mind that penny stocks lend themselves well to scams like the “pump and dump,” and a lot of the information about them out there could be corrupt and manipulative. So proceed carefully.
Penny stocks that are traded over the counter are also traded less frequently than exchange-traded stocks, which means they have less liquidity, which means it’s harder to find a buyer for them. So if your stock starts to plummet, you might very well be stuck with it or have to sell it at a significant loss.
Ultimately, it takes a lot of research and a healthy dose of luck to not lose money on penny stocks. The cheap buying price and the promise of quick wealth is tempting, but the risks are high enough that we can’t advise investing a significant part of your money in them. If you do want to try your luck, make sure that the money you invest is an amount you’re comfortable potentially losing forever. And cushion yourself against losses by ensuring you have a well-balanced diversified portfolio.
Buying penny stock
If you want to buy penny stock, you won’t find them on a regular exchange market. You’ll have to find a broker who specializes in OTC stocks, or go through an OTC Bulletin Board (a type of listing service that displays the different kinds of penny stocks on offer). Because of the risky nature of penny stocks, it really should be a minimal part of a well-balanced portfolio, if at all.
If this all sounds too stressful and speculative, then low-cost, steady ETFs that offer the possibility of stable, long-term growth might be more up your alley. We’re certainly a little biased, but we think the best home for a first-time investor, or a hundredth-time investor for that matter, is Wealthsimple. We offer state of the art technology, low fees and friendly financial advice. Sign up now or find more details here.