The allure of penny stocks isn’t surprising. The idea is to buy low-priced stocks with huge growth potential and then make a robust profit by selling if they go up substantially in value. The problem is that many people don’t understand how big of an “if” that is. Penny stocks are often subject to major manipulation because they exist in the wild west of the market with few rules. So when you invest in penny stocks, you’re taking on a lot of risks, but that’s not to say you can’t see decent returns. We’ll help you understand whether investing in penny stocks is right for you and how you can do so in a smart way. But because of the risk involved, you may want to work with a financial advisor who can advise you for your financial situation.
What Is a Penny Stock?
Shares of penny stocks are investments in companies that usually trade for less than $5 per share. Say you purchase 10,000 shares of a stock at 30 cents per share and the price then goes up to $1 per share. If you sell at this time, you’ll make $7,000, more than doubling your money. Sound too good to be true? You have to be careful, of course, given the sizable risks associated with this type of investment.
Risks of Investing in Penny Stocks
Many companies that are listed as penny stocks hire promoters to sell these stocks. They reach out to potential investors through emails, newsletters and cold calls. Oftentimes, these promoters hype up the stock and their company’s capacity for success.
Over-promotion of penny stocks may signal a “pump-and-dump” scheme. When this happens, traders purchase stocks at very low prices. They then hype up, or “pump,” the potential value of the stock to get inexperienced investors excited. When the rise in demand elevates the stock price, traders sell the undervalued stocks for a profit. This move eventually causes the price of the stock to plummet.
Moreover, penny stocks exist on the over-the-counter (OTC) market rather than large stock exchanges like the Nasdaq or the New York Stock Exchange (NYSE). This means companies with penny stocks don’t need to follow the same strict rules as companies listed on the big exchanges. For instance, many companies with penny stocks don’t even have to report their financials or register with the U.S. Securities and Exchange Commission (SEC). This makes it hard to research a company, which is an essential part of investing wisely.
Some companies selling penny stocks are either struggling or facing legal trouble. With that said, it’s not surprising why certain companies may want to keep their financials hidden from potential investors. If you can’t find anything about the company’s earnings and other crucial financial information, you probably want to keep your money away from that firm.
However, that doesn’t mean every penny stock is steeped in schemes. Some companies with penny stocks have promising potential, and others that seem to be in bad shape could be looking at major comebacks.
If you feel you have the stomach and risk tolerance to dive into the world of penny stocks, there are several approaches to doing it the right way.
Do Your Homework Before Investing
Before you invest in a company’s stock, you should supplement your overall understanding of stocks by learning as much as you can about the company. Dig into the company’s earnings, profits, expenses and as many other details about its financials as you can find:
- Study the competition and the industry sector the company operates in. Take a look at the company’s history and the reputations of those who manage it. You can find this information from several sources such as the company website, the SEC and reliable sites that track stock performance.
- Seek penny stocks that trade at around 100,000 shares a day. This usually makes it easier to sell your stocks.
- Try aiming for companies with strong earnings records and consistent performance. Of course, past performance does not guarantee future results.
- Be aware of potential conflicts of interest. Some companies place disclaimers in the emails, newsletters and other materials that they use to promote the stock. It’s important to read these carefully.
If it’s harder than usual to find this information, that should be a major red flag. You want to invest in companies that you can properly research and see a clear roadmap for that gives you hope in building your portfolio.
Diversify Your Portfolio
One of the best ways to hedge against potential risk, especially when you’re dabbling in penny stocks, is to diversify your investment portfolio as best as you can. Some professionals recommend that you devote no more than 10% of your individual stock holdings to penny stocks.
It’s also important to understand your risk tolerance. Generally speaking, the higher your risk tolerance, the more equipped you are to take on the risk that can come with investing in penny stocks. Our asset allocation calculator can help you get a glimpse of your proper investment mix based on different levels of risk tolerance.
It’s a good idea to keep it modest when it comes to the number of shares you purchase in penny stocks. Many new investors get greedy and drop as much as they can on penny stocks with the belief that they stand to make that much more in return.
How to Avoid Broker Fees on Penny Stocks
For the amount of money that you’re investing into a penny stock, you don’t want to pay typical broker fees or it may not be worth it. Working with the right broker will help you avoid excessive fees. Some brokers require you to pay large surcharges to acquire penny stocks if the share price falls below a certain level. Others can also impose hefty fees based on the number of shares you trade.
Nonetheless, you can find brokers that don’t enforce these surcharges and let you trade penny stocks as if they were on major exchanges. This arrangement would keep trading expenses at a minimum. SmartAsset’s online brokerage comparison tool can help you find the best trading platform for your investing needs.
The Bottom Line
Penny stocks get a lot of attention but they involve plenty of risks that you should be aware of before pulling the trigger. They sell low for a reason, and some promoters may over-promise and under-deliver on returns. So do your homework, and make sure you’re prepared. Invest in companies that have a substantial amount of evidence ready to back up their potential for growth. And don’t forget to diversify your portfolio and take every step you can to protect against potential difficulties.
Tips on Investing in Penny Stocks
- Because of the deep pitfalls, you may encounter when investing in penny stocks, you may want to work with a financial advisor to guide you through the process. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re investing in penny stocks, you should do it with your discretionary income. Don’t take on the risk by digging into emergency funds, retirement savings or other crucial sources of funds.
- A key to successful investing is not putting all of your eggs in one basket. An easy way to diversify is by investing in mutual funds or exchange-traded funds (ETFs).
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