5 Reasons Not to Invest In Penny Stocks

Because of some of the methods of advertising we include on this site, you will sometimes see the odd advertisement for penny stocks come up.  Please don’t mistake this for an endorsement of that style of investing.  If not on our site, I’m sure you’ve come across banner ads that tout magical returns of “1001% In a Few Short Months!” or something similar.  In this case, the old adage your parents used to tell you about if something was too good to be true – is correct.  Penny stocks are roughly equivalent to going to the horse track and throwing down your “investment money” on *mostcreativename*.  It is not a realistic philosophy for trying to build a nest egg.

I’m an advocate of index investing (check out our FREE e-book on the matter here), but hey, if long-term dividend investing, or some combination of long-term strategies that involve things like trying to find value is what floats your boat, I think you’ll probably be ok.  Statistics say you’d almost assuredly be better off with a low-cost couch potato/indexing strategy, but as long as you’re semi-rationale and not just trying to get rich quick, you’ll probably be alright.  Penny stocks are another thing entirely though.

invest-penny-stocksBefore I get into why penny stocks (or micro-caps as they are known in investor parlance) are a bad idea for nearly every investor out there, I should explain just what a penny stock is.  Exact definitions vary, but basically stocks with a share price under a dollar, or an overall market capitalization (market cap) of under $100 million usually fall into most peoples’ idea of a penny stock.  Penny stocks are relatively small companies that are not found in larger indexes, and are pretty far off of the “beaten path” of investing.

Here’s Why Penny Stocks Aren’t Cool

1) There is very little information on them.

Because these companies are so small there is very little public information on them.  There is often little-to-no third party coverage of penny stocks, and even less that is trustworthy.  The companies represented by penny stocks often don’t have the manpower or expertise to put out detailed quarterly reports, and many penny stocks are not regulated in the same way major companies on the S&P 500 or TSX 60 would be.  This creates a very risky and inefficient market.  Investing on fundamentals and basic metrics at this point is impossible.

2) There are not many shares available to be traded.

This is bad for a couple of reasons.  The first disadvantage is that you might have a hard time finding a buyer for your penny stock because of a “lack of liquidity”.  The more worrisome consideration about this characteristic is that it leaves penny stocks at the mercy of people who want to manipulate the stock price for short-term profit.  This common strategy is known as the “pump-and-dump”.  The idea is to pay to drum up some short-term interest in a stock, invest some money and drive the share price up, then broadcast as widely as possible the “75% overnight gains” the stock has made.  At this point a solid number of “get-rich-quick-types” will pour into the stock, further juicing the numbers, just as the original con-men pull out and rapidly sell off their position.  The result is that the Johnny-come-latelies are left holding a very expensive bag of nothing.

3) Most penny stock tips are put out by people paid to pump them up.

It is a pretty well-known fact in investing circles that most penny stock newsletters are a sham – or are at least highly biased.  If you read the small print of these publications they will often admit to taking financial compensation from the very companies they are proposing to give neutral advice on.  It would almost be as bad as the large ratings agencies trying to put bond ratings on the banks that they hope to work for one day – oh wait, that’s already happening?  How’s that working out?  The bottom line for me is not to trust anything with the words “penny stock tips” attached to it.

4) These companies do not have durable competitive advantages.

I’m a big Warren Buffett fan.  If you’ve read anything by the Oracle of Omaha you probably heard the phrase “durable competitive advantage” thrown around.  This is basically the idea that a company has something about it that will go along way to preserving its advantages for the foreseeable future.  For example, Buffett owns a lot of Coca-Cola stock.  Is Coke the only company that can make brown, fizzy, sugar water?  No, BUT it is the only soda company that has certain brand and distribution characteristics.  Penny stocks are almost always relatively new companies that have yet to define and dominate their niche in the market place.

5) Penny stocks aren’t “on sale”.

It always surprises me how many people there are out there that have done just enough reading on a topic to be dangerous to themselves (and not nearly enough to truly understand what is going on).  There are many people out there who benefit big time by promoting the idea that because a stock costs very little, the company is “on sale”.  This is ridiculous.  Please stop and consider that the actual dollar price of a stock does not really mean anything in terms of if you should invest in it or not.  If there are 100,000 shares of Company A on the market trading at $.03, and 1,000 shares of company B trading at $3.00 you are getting exactly the same value for your dollar if all other things are equal.  If you have not yet done enough reading to become familiar with basic investing metrics such as price-to-earning rations (P/E) or dividend ratios, please do yourself a favour and budget about 30-50 hours of reading time in before you even look at trying to figure out this stock-picking game.  Again, to reiterate, a “cheap” stock price (or rather “very low stock price”) by itself does not mean it is a “good deal” – in fact it has nothing to do with whether you are getting good value for your money or not.

I should also note that I do not equate throwing darts/picking penny stocks with what talented and motivated investors are able to do in the mid-cap arena, or even in certain small-cap stocks (companies in the $500 million-$10 billion range).  I think there are guys out there (definitely not me) who have the background, talent, and work ethic to research these stocks and actually take advantage of the fact that they don’t receive much media attention (amongst other inefficiencies that can be exploited).  Many of these companies have fairly substantial track records, and solid growth numbers over a relatively long period of time.  There is also much more information available on these companies than those in the penny stock universe (even if not many people bother to read it).

So before you go out and try to make a million dollar in the next 90 days without leaving your computer seat simply by subscribing to a couple of penny stock newsletters and opening a brokerage account, take a deep breath and think about this.  If it were that easy, wouldn’t people smarter than you be doing it?  Anyone out there been burned by penny stocks, or think that they have mastered this extremely trick art?

About Kyle Prevost

Kyle is a high school humanities teacher by day, and freelance personal finance author by night. He has been published in academic journals, and has also co-authored the book "More Money for Beer and Textbooks". In his free time Kyle likes to limp up and down a basketball court and pretend to be a tough guy in a boxing ring.

3 Responses to 5 Reasons Not to Invest In Penny Stocks

  1. I agree with everything you wrote above. When I was learning how to do technical analysis I used penny stocks as a starting point to see if I could apply what I learned. I put $500 into my TD Ameritrade account years ago and started researching. After about a month I was up roughly 75%, granted on $500 isn’t much but made me feel pretty good that I was able to successfully apply what I learned. Of course I made a blunder and fell for one of those ads. I was young and naive. I haven’t had the money to try again since then.

    • I think there is such low liquidity in penny stocks that trying to do technical analysis is extremely difficult – and I’m not even sure I believe all that much in technical analysis anyway! Mid-cap companies are another matter. I think in 10 years or so when I’ve had some time in the markets and have a higher income I’ll test those waters a little more.

  2. This is because they are much more risky and if you have no information on how to go about it, you will lose it all. And reason being they dont have no minimum standards.

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