At some point in every investor’s career there are bound to be aspirations of striking it rich trading penny stocks. That dream is usually short-lived after actually attempting it though. That’s because penny stocks are the school bullies of the stock world. They’ll take your money and leave you feeling beaten down while at the same time lowering your self-esteem. If you don’t want to take my word for it though, here are just a few reasons you should avoid them.
Trap for Inexperienced/Young Investors
If it sounds like I have a personal vendetta against penny stocks it’s because I do. When I first started investing I wasn’t working with a lot of money so the more expensive blue chip stocks seemed so far out of reach. Those penny stocks on the other hand started to look pretty tempting when I realized I could buy about a billion shares for a few dollars. Well, fast forward a few years and the “you get what you paid for” saying rang true here. The penny stocks had successfully taken my lunch money.
You may be thinking “it’s only a few dollars. What’s the big deal?”. A few dollars really isn’t a big deal, but penny stocks are a slippery slope. Once you start investing in one penny stock you start looking for others. Then you grow attached to the companies because they were some of the first you invested in. Even as you watch the price consistently tick down you try to convince yourself that they’re going to hit it big. It’s hard to swallow your pride and admit you made a bad investment, so you double down and buy more hoping you’ll get lucky. Then you realize just how much you have invested in penny stocks that could’ve been invested in more legitimate companies.
They Perform Poorly
There’s a reason these stocks are so cheap. Whether it’s due to a bad product, bad service, or poor management these companies aren’t exactly performing at the top of their game. When a company doesn’t do well that typically leads to a drop in stock price, and that is especially true with penny stocks. The chart below shows the price trend of one of the penny stocks I invested in when I first started. There was one major spike but overall it trended down and down… and down… and down.
Usually by the time a company reaches penny stock status it has proven that it doesn’t perform well or isn’t able to scale. It’s not surprising to see a slow bleed-out until they get de-listed from the major exchanges and/or go bankrupt. Plus most don’t pay a dividend because the don’t have the capital to be able to do so. All around a pretty crappy deal if you ask me.
Require More Attention
With a good stock you can buy it and forget about it, but with a penny stock you really can’t do that. As the chart above showed, penny stock prices can jump exponentially for a very short period of time and then fall back down just as fast. You have to be ready to take advantage of the spikes immediately if you hope to secure any sort of profit.
Additionally, you have to constantly monitor headlines for news about the company or the industry they operate in if you really want to be on top of things. The smallest detail can cause these stocks to shoot up or down wildly in a way that normal stocks do not. The extra work required and the seemingly random volatility can cause a lot of undue stress that’s just not worth it.
It’s Basically Gambling
When you buy penny stocks you’re gambling more than investing. There are just so many variables that it’s almost impossible to try to figure out which ones will succeed. It’s also harder to find information on these companies compared to normal stocks, so even if you try to do your research you might come up empty-handed. Many times the information that actually is available is skewed to meet someone’s personal agenda. There’s a perfect example of this in The Wolf of Wall Street.
They play by a totally different set of rules in this space, and it’s really not worth the trouble to learn them. If you want to gamble you’ll have way more fun trying your luck in Vegas… and probably a better chance of coming out as a winner.
Penny stocks typically have very comparatively low market caps which means they are prime for being manipulated. Due to the lower market cap it takes substantially less money to influence the price of the stock. This may come as a surprise, but there are unsavory characters out there that seek to exploit it.
The “pump and dump” is one of the shady tactics that plagues this industry. People will artificially pump up the stock price through buying large amounts/and or spreading false information. Unassuming investors buy shares thinking that there’s a good reason for the increase. Then the original buyer will sell their shares at the higher price and rake in the profit. Once they have their profit the stock price comes cratering back down. Pump and dumps are much much harder to pull off with more legitimate stocks because they have way higher market caps and are more regulated.
Can Be a Pain to Buy
Many penny stocks aren’t even available to buy on the major exchanges, so you’d have to go to the OTC exchanges. These are less regulated and can potentially be a pain to buy from because your brokerage of choice may not support them. Many brokerages purposely don’t support them due to their volatile nature and poor track record. It’s almost like they’re trying to protect their investors from something…
Penny stocks are basically the hot stove your parents told you not to touch when you were a kid. You know you should stay away but there’s just something alluring that draws you in. At the end of the day you just end up getting burned though. If you want some tips on how to pick some less sucky stocks then check out this article.