Let’s not kid ourselves. Wealth is incredibly alluring. Who wouldn’t want to have the money to vacation in this sick party palace in Sands Point, Long Island? Unless you wake up one morning to discover you’re Taylor Swift, the most common way people imagine getting rich quick is through investing. A video like this one, starring a Rolex, a big pile of money and the keys to a Lambo and Porsche, would have you believe that that investing in penny stocks is the absolute best way to get rich quick.
If that house we just showed you above looks at all familiar, it’s because it was the Quaalude-rich beach house Martin Scorsese used for 2013’s The Wolf of Wall Street in which Leonardo DiCaprio portrayed finance’s canis lupus himself, Jordan Belfort. Before going to prison, Belfort indeed got very rich very quick through penny stocks, but not by following the stock tips from a newsletter or a YouTube video. Belfort convinced small investors like yourself that they would get rich by purchasing penny stocks. These sales would artificially inflate the price of those penny stocks. Belfort would then sell his company’s positions in those same stocks, which would crater their value and leave those who’d followed his advice holding a worthless stock. At his sentencing in 2003, Belfort was ordered to pay $110 million to his victims, which, surprise, since he seems like such an otherwise solid dude, he hasn’t yet done. Belfort’s was running what’s called a pump and dump scheme, and as story after story will illustrate, pump and dumps are the financial scam most often associated with penny stocks.
Why would something that sounds so cute like penny stocks represent such a hazard for investors?
What’s a penny stock?
Before delving further, let’s take a step back and define our terms. The term penny stock is a little deceptive, since very few if any will actually cost as little as a $.01. The Securities and Exchange Commission, in their valuable report on them, prefers to refer to penny stocks as “microcap” stocks, and defines them as companies with market capitalization of less than $300 million. Since penny stocks are virtually unregulated, there’s no precise price point which would make a stock qualify as a “penny stock” though most sources agree that penny stocks trade for less than $5 a share.
Everyone can agree on one penny stock trait, however. No penny stock will trade on any major stock exchange like the New York Stock Exchange or NASDAQ. This doesn’t mean that cheap stocks are necessarily penny stocks. Rite Aid Corporation, for instance, trades for a heck of a lot less than $5.00 a share, but since it is listed on the New York Stock Exchange, would never be referred to as a “penny stock.”
How to trade penny stocks
If you even skimmed the preceding paragraphs in three seconds with one eye just a quarter of the way open, you’ll understand that trading penny stocks couldn’t be riskier. But if you must trade, here’s how.
- Paper trade first. Try trading penny stock first using only imaginary money—paper trading, it’s called. Pick your stocks, track them for a pre-determined number of weeks, and see how you fare. If you win big for the specific reasons you predicted you would win big, you might be ready to commit some real money. With all those imaginary winnings, be our guest and treat yourself to a week-long imaginary holiday in Hawaii.
- Do your homework. There’s so much lousy, corrupt information out there about penny stocks, it may prove difficult to find a consistently reliable source on the matter. Suffice it to say, don’t trust any one source on anything, and assume that even if you find two sources recommending the same stock, they may be in cahoots. Sure, it may sound like we’ve gone into paranoid, tin foil hat wearing territory, but scams can to be pretty well coordinated. Despite the fact that he happens to have made his name in penny stock trading, financial personality Timothy Sykes offers some pretty sage advice in this article, including, “ignore penny stocks success stories,” and “read the disclaimers.”
- Buy through a broker. Don’t ever buy penny stocks directly from someone who, for instance, calls you on the telephone to pitch you an investment opportunity. If you fall for this, we have another cool investing opportunity you might consider. Since penny stocks tend to be so inexpensive, you’ll want to find a platform that not only trades OTC stocks, but also offers very low commission, if not commission-free trades in order to make sure that nearly all of your money winds up in the invested, not spent on fees. Human brokers tend to charge multiples of what an online brokerage would charge, so avoid them if at all possible. If you need to bone up on the DIY approach, this How To Buy Stocks guide should provide a solid helping hand.
How penny stocks are traded
All penny stocks are sold over-the-counter, or OTC, but unlike with your local Rite Aid and grape cough syrup, there’s no actual “counter” over with to purchase anything. OTC simply means that they’re stocks that are not listed or sold on an exchange. You’ll often hear these stocks referred to as “unlisted,” which may sound fancy and exclusive, like a secret Kardashian phone number, but it’s in fact just the opposite. OTC stocks don’t trade at any centralized location, but instead through dealers via phone and computer.
The risks of buying penny stocks
The fact that penny stocks aren’t listed on a centralized exchange is what makes them particularly dangerous for most investors. People may complain about the cheating ways of big corporations, but the truth is, in order to be listed on any public exchange like NASDAQ, a company must by law disclose a good many facts about their finances. So while Apple must file public earnings reports on a quarterly basis, OTC companies aren’t required to do anything of the sort. In other words, if someone tells you an OTC company’s new fidget-salad-spinner combo is flying off the shelves in Japan, and their stock will soon double, you’ll just have to take their word for it. Do you trust these folks to tell you the truth?
In its big 2016 paper, the SEC was pretty decisive on how much of a suckers’ bet penny stocks tend to be: “A synthesis of recent academic literature reveals…that OTC stocks tend to be highly illiquid; are frequent targets of alleged market manipulation; generate negative and volatile investment returns on average; and rarely grow into a large company or transition to listing on a stock exchange.”
Liquidity and manipulation are both keys to their inherent danger for investors. Markets operate on according to the law of supply and demand, and the more a stock is traded on any particular day, its so-called “share volume.” Higher liquidity tends to create a pretty streamlined source of buyers and sellers who basically agree on the price a stock should buy and sell for. Should a stock be illiquid, that is have a share volume of considerably lower than a million shares per day, this will contribute a growing “bid ask spread,” the difference between the price buyers are willing to pay, and sellers are willing to sell. If you’re trading Apple, which trades millions of times a day, the bid-ask speak might be a penny. If you’re trading Flybynight Discount Airlines, a penny stock that trades six times a day, the bid ask spread might be significant, which makes getting rid of your position in a stock to be incredibly difficult unless you’re willing to settle for a lot less. Getting rid of a penny stock could become like unloading a house in a week—if you want to sell a house very quickly, you have to be willing to lose a big percentage of your investment. When a stock is pumped, then dumped, sellers will have virtually no market to sell their shares.
Manipulation is the creative engine of the old “pump and dump” scam, some unseen force that seeks to move a penny stock in one direction or another in order for the schemer to profit from the movement. A few years ago, a federal judge sentenced a guy named Gregg Mulholland to twelve years in prison for boosting the stock of a “social network” business called Cynk Technology that had neither revenue nor assets 24,000% and pocketing $250 million in gains after dumping the company stock at its height. Using aliases like “Charlie Wolf” and “Stamps,” Mulholland represented himself to potential investors as an uninterested party with a hot stock tip. This is the danger of a lot of the intel you might find on penny stocks. Because there’s so little public information on these companies, the stock prices are frequently manipulated by interested parties masquerading as neutral observers. They will seek marks by sharing their tips in places like newsletters and mass emails.
If someone you don’t know ever tells you he comes bearing the key to make you rich quick, you should treat them as you might a stranger who emails you with a tale of a Nigerian prince’s fortune that only little-old-you have the power to liberate. Wake up, sheeple. Don’t let this happen to you!
Need more inspiration to run screaming from penny stocks? Read this article from Kiplinger’s, “Penny Stocks: Why You Should Always Stay Away".
Alternatives to buying penny stocks online
The biggest draw of penny stocks may be their low cost. A single Berkshire Hathaway A share too rich for your blood by a factor of 10,000? Penny stocks will be far more appealing. But these are hardly the only opportunities for investors looking to invest with a small amount of money.
Consider an ETF instead
If you’re at all familiar with the philosophy of the father of Modern Portfolio Theory, Harry Markowitz, you’ll know that he believes the key to successfully investing is diversification, that is, not putting all your eggs in one (investment) basket. So rather than investing in one or a handful of penny stocks, you might instead consider buying a little sliver of the biggest 500 companies in the American economy through buying a (fairly affordable) share in an S&P 500 tracking ETF like those offered by any of a number of big investment advisors. (Of course, ETFs and all other stock investments are speculative, and you need to understand that you may lose some or even all of your investment.)
Consider a robo advisor
Certain automated investing services, in exchange for a reasonable annual fee, will provide you a fully diversified portfolio of stocks and bond ETFs if you can come up with as little as one dollar to start. An account can even be opened with zero dollars, though the returns on an investment that size tend to be pretty disappointing.
Can’t afford to invest a couple hundred dollars in an ETF? How about the $.37 to round up your $2.43 coffee purchase to $3.00? A few ingenious apps have popped up that now allow you to invest the spare dimes, nickels, and quarters by rounding up to the nearest dollar any purchase you make with your credit or ATM cards. The big ones will allow you to begin investing with as little as $5.00.
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