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What Are Penny Stocks?

Every once in a while you hear about some lucky person who got rich by trading penny stocks. And we’re happy for those people – we really are. But for the average investor, penny stocks are risky business. Let’s talk about penny stocks, what they can offer you and what they can’t.

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Penny Stock Defined

A penny stock is a cheap stock, generally one that sells for less than five dollars and does not trade on a major exchange. Companies that are just starting out or are struggling often issue penny stocks. These trade on “pink sheets” rather than on a major stock exchange. The market for penny stocks is also called an “over-the-counter” (OTC) market because it doesn’t come with the same level of oversight that you get on a major market.

What Are Penny Stocks?

Penny stocks don’t have to register with the SEC or meet SEC requirements. As a result, the penny stock world is sometimes called the “Wild West” of investing. Penny stocks could come from worthless companies, or from shell companies that don’t exist at all. You’ll be hard pressed to get the fundamentals on the companies that issue penny stocks. That makes it hard to do your due diligence as an investor. It also increases the risk that comes with buying penny stock.

Now, there’s nothing inherently bad about a penny stock. Some legitimate companies with real growth potential offer them. But the reason penny stocks have a less-than-stellar reputation is that they have a history of high risk, fraud and mis-management. Ever seen Boiler Room? Or The Wolf of Wall Street? Then you’ll know that penny stocks can make fortunes for traders and wipe out investors. If you’re considering getting into the penny stock game, it’s important to be aware of the risks involved.

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The Risks

What Are Penny Stocks?

One risk with penny stocks is that they can be magnets for “pump and dump” schemes. In a pump and dump, traders buy stocks at ultra-low prices. They then inflate (“pump”) the price of that stock by misleading potential investors, only to turn around and sell (“dump”) the overvalued shares at a high profit. Think traders making cold calls to unsophisticated investors and touting get-rich-quick schemes through penny stocks and you’ve got a good idea of how pump and dump works.

As always with investing, it’s a good idea to be suspicious of anything that sounds too good to be true, and check the credentials of brokers and brokerage firms. These days, a scam probably won’t come in the form of the cold call on your home phone that’s depicted in the movies. Instead, it will likely be an email or website that tempts you into parting with your hard-earned dollars and leaves you with little or nothing to show for it. It could be a “hot tip” in an investing forum that’s set up to lure unsuspecting investors.

SEC Advice

The SEC warns that investors in penny stocks should be prepared to lose their entire investment – or more than that if they buy penny stocks on margin. The SEC also offers some solid tips on avoiding scams. They boil down to:

  • Do Your Research
  • Be Skeptical
  • Take High-Pressure Pitches as a Bad Sign
  • Understand That OTC Stocks Are Higher-Risk

The idea behind buying penny stocks is to beat or outsmart the market by buying “undervalued” stocks for low prices and then selling them when the value increases. Some would argue, though, that there’s no such thing as an undervalued stock. Let us explain.

According to the Efficient Market Hypothesis, the market sets the price of stocks based on all available, reliable information. Folks who believe that markets are efficient would say that if a stock has a low price it has low value, too. That means that there’s no such thing as getting a hot tip on an undervalued stock because there are no undervalued stocks.

How to Buy Penny Stocks

If risk doesn’t bother you, you can afford to lose some money and you’re drawn to penny stocks, you’ll need to employ the services of a stockbroker to get in on the action. Your best bet is probably to start small to see if investing in penny stocks is for you.

Related Article: How Does the Stock Market Work?

The Takeaway

If you’re someone who enjoys investing as a hobby and a recreational activity, you may be happy riding the roller coaster of penny stocks. Just remember that high-risk trading should be something you do with your “fun money,” not your emergency fund or your retirement savings. For money that you’re really going to need, you’re probably better off building a diversified portfolio of low-cost investments.

Photo credit: flickr, ©iStock.com/spxChrome, ©iStock.com/

Amelia Josephson Amelia Josephson is a staff writer covering financial literacy topics at SmartAsset. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.

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