Eager new investors who are short on cash often look to penny stocks. They’re very attractive since they’re so cheap, and between the internet and the water cooler at work, it’s quite common to hear stories of people who have made colossal returns when their stock’s value went from pennies to dollars.
But are those stories too good to be true? Are penny stocks a worthwhile investment?
I was allured by penny stocks when I first started investing. I noticed that the stocks labeled ‘top earners’ in my trading app each day were often very inexpensive, often just a few dollars.
Though these top-earning stocks had only gained a few cents, the percentage returns were awesome. I thought if I could time it right and snag a $1 stock that jumped $.50 in a day, I could make a huge return in no time.
If you’ve ever pondered investing in penny stocks, read on to find out more about the risks and benefits, as well as our take on whether penny stocks are worth your time and money.
What are Penny Stocks?
The Securities Exchange Commission (SEC) defines a penny stock as any stock with a price of less than $5. The cutoff used to be $1, hence the ‘penny stock’ name. While you can find a few stocks that meet that definition on the New York Stock Exchange (NYSE) or NASDAQ, most of these types of stocks are traded on forums or alternative exchanges.
These “over-the-counter” exchanges (called OTCBB and Pink Sheets) have fewer regulatory and reporting requirements than their mainstream counterparts.
It’s a common myth that all companies start out as penny stocks and subsequently grew to the giants they are now (though this has happened in a few cases, Amazon and BJ’s Restaurants being two notable examples).
In fact, many companies that no longer meet the requirements of the NYSE or NASDAQ get delisted (kicked off), then cling to life as penny stocks.
Some of these companies (like Ford and Pier 1) make stellar comebacks, rewarding those that hold on during stormy economic times with amazing returns. Others go out of business, leaving faithful investors with nothing to show for their loyalty.
What Are the Risks With Investing in Penny Stocks?
The Securities Exchange Commission (the federal governing body that regulates the stock market) dubs penny stocks as risky investments.
In fact, before you buy your first penny stock, they make you sign a statement acknowledging that recognize these risks and that you may lose your entire investment.
You may be wondering why they are categorically regarded as risky. After all, isn’t the only defining attribute of a penny stock the cheap price? Surely there must be a few companies that are just down on their luck, ready to spring back to new heights.
While every penny stock investor dreams of finding these diamonds in the rough, the truth is a lot less shiny. It’s not just a bad reputation—these stocks are worth pennies a reason. (Several, actually.)
Here is an overview of what makes penny stocks riskier than their mainstream counterparts.
This is the double-edged sword that makes penny stocks so attractive—and dangerous. Volatility is how far up and down the stock price tends to fluctuate, and penny stocks are extremely volatile.
This is partly due to the low price. If you buy XYZ stock at $1.00 per share, and it gains $0.15 in value, that’s a 15% return.
If a larger stock like Amazon or Wal-Mart gained $0.15, that’s mere static on the radio and wouldn’t even register as a percentage of the stock’s price.
The inverse is true as well—a $0.50 loss in AMZN or WMT stock isn’t worth mentioning, but the same loss in a penny stock could be devastating. In short, pennies mean a lot more when you’re dealing in penny stocks.
Low Trading Volume
Because penny stocks are traded on non-standard exchanges, there are fewer people trading them. This creates a big spread between the bidding price of the buyers and the asking price for sellers.
With stocks like Target or GE, this spread is a few cents at most, but for penny stocks, this can often be 25-33% of the stock’s value. With this big of a gap, you can lose the majority of the value of the stock just in the spread!
Lack of Liquidity
To sell a stock, you need a buyer. That’s as true for penny stocks as it is for larger, established stocks. Since there are so many more people trading large stocks on the NYSE every day, you can almost always find a buyer or seller for those.
Penny stocks, however, are a different story.
Because the companies behind penny stocks are so small and often in a localized market, it may be a lot harder to offload your shares if you decide that a certain stock isn’t working for you.
Penny stocks are an illiquid (hard to convert to cash) asset, and that adds to their riskiness.
Lack of Regulation
The stock exchanges you know of (NYSE and the Nasdaq) vet companies thoroughly before allowing them to be traded on their exchanges. While these standards don’t guarantee you a return on your investment, they do provide a bit of a safety net, since you know you’re investing in a legitimate company.
What happens to the companies that don’t make the cut for the major stock exchanges? They end up as over-the-counter penny stocks that trade on non-standard exchanges, such as OTC Bulletin Board and Pink Sheets.
These alternative marketplaces have few reporting requirements, so the stocks traded on them range from the legitimate little guys who are looking for a big break to companies with no assets or revenue that are mostly smoke and mirrors.
This lack of regulation opens the sector up to fraudsters. Beware of social media posts, newsletters, and emails promising stellar returns on penny stocks.
Oftentimes these are pump-and-dump schemes where the ‘experts’ recommend stocks they’ve already bought to create interest and drive up the price. The con artists then sell their own shares at the top, leaving other, inexperienced investors to take the losses when the price falls.
What is the Upside of Trading Penny Stocks?
Penny stocks are admittedly risky, but this asset class isn’t entirely without merit. Here are some of the biggest benefits of trading penny stocks.
Low Barrier to Entry
Since the prices on penny stocks are so low, the barrier to entry in penny stocks is not as great for investors with a small amount of cash.
There’s no need to save for weeks or months to have enough cash to invest in penny stocks—you can get started quickly and cheaply.
Potential for Huge Returns
If you have the stomach to buy and hold on when major stocks plummet into penny stock territory, you may be handsomely rewarded.
If you had bought Ford stock when it hit $2 during the Great Recession and held it until today, you’d have made a 600% return! Buyers of Monster Beverage Corporation would have seen $2 a share grow to $95 a share today.
These stories may be few and far between, but they DO exist, and picking the lucky winner can mean lottery-style returns.
Low Cost of Failure
If you buy even one share of Tesla or Alphabet, Inc (Google) stock, it will cost you quite a bit, forcing you to put a lot of your eggs in one basket. If the stock tanks, you’re out hundreds or thousands of dollars.
However, with penny stocks, the risk of failure might be higher, but the cost of failure is much lower. If the company goes bankrupt, you’re out a few bucks per share and the commission, not your entire savings.
You can spread your money much further if the stocks are cheap, betting on multiple companies to see which one will make it big. If one penny stock does well enough, it may cover the losses in others.
Our Take – Are Penny Stocks Worth it?
If you’re willing to really do some digging for reliable information and you have the time and understanding to educate yourself on the underlying company, it is possible to find a penny stock that will give you amazing returns.
But if you don’t have the time, access to company info, and money you can stand to lose, consider investing elsewhere.
I personally don’t hold any penny stocks. I dabbled in a few cheap stocks early on in my investing career (a handful of shares on Webull), I lost money most of the time.
Now, I do a lot of buy-and-hold investing because babysitting stocks for quick, one-day jumps isn’t how I like to monitor my investments. I’d rather wait for compound interest to work its magic on tried-and-true equities than to take on the extra risk penny stocks represent.
If you insist on investing in penny stocks, keep a few principles in mind:
- Penny stocks are a speculative investment and should NOT be a part of your retirement or long-term investment strategy. The bulk of your long-term investments should be in well-established asset classes like stocks, bonds, or real estate.
- Only invest as much in penny stocks as you are willing to lose. Playing penny stocks is risky, just like a trip to the casino, and should be treated as such.
- Know that the odds are against you. While you may have heard stories of your brother-in-law’s nephew’s girlfriend who struck it rich, you won’t hear the sad stories of many more people who are too embarrassed to mention that they lost most of the value of their investments in penny stocks.
A Viable Alternative to Penny Stocks
If you are strapped for cash but still eager to invest, consider looking for cheaper stocks on the NYSE. You can sign up with a mobile trading app like M1 Finance to find dozens of inexpensive stocks that are issued by legitimate companies.
Look for industries that have taken a temporary dive but are poised to make a comeback (like tourism-based companies during COVID-19), or small companies with great growth potential.
I snagged Zynga (ZNGA, an up-and-coming mobile gaming company) for $8.20, and I’ve made a 20% return in just a few months of owning it. I also bought Southwest Airlines stock (LUV for $38 during the pandemic. If I’d held onto it until now, I’d have made a 157% return!
If the price of investing seems too high with normal stocks, note that M1 Finance, Robinhood, and other trading apps also offer fractional shares—small slices of stocks, which make behemoths like Amazon and Berkshire Hathaway affordable investments for everyone.
The Bottom Line
Due to their cheap cost and potential for high returns, penny stocks can be very enticing—particularly to new investors that don’t understand the risks involved.
Penny stocks aren’t just baby companies, poised to grow; they are often cheaply priced because they don’t meet the standards of the New York Stock Exchange.
Their low trading volume, lack of liquidity, and loose regulatory requirements make penny stocks a speculative investment. A few penny stocks do go on to make it big, but many do not.
Before you spend your hard-earned money, ask yourself why you’re investing in the first place. Are you looking for a quick win for fun and the thrill of the chase, or are you seeking long-term wealth?
If it’s the latter, penny stocks may not be your best bet. Instead, consider buying inexpensive stocks of legitimate companies or fractional shares of more established companies on a trading app like M1 Finance or Acorns.
There are deals to be had on cheaply priced stocks, but don’t assume that what goes down will come back up. As with any investment, do your research to determine if a stock is worth your time and money, even if it only costs pennies.