Why You Should Avoid Penny Stocks


Have you ever received a random email touting the benefits of a company or its recent business success?

How many times have you been on a financial forum and seen some random posts about a stock that is “poised to see explosive growth” or some other crazy claim?

Or have you ever used a stock screener to find an attractive stock, but were shocked to see the share price was only 10 cents?

Whether you knew it or not you were being prospected for penny stocks.  These dangerous stocks are deployed by scammers to steal money from you, but can be confusing to understand.

Avoid Penny Stock Scams


What exactly is a penny stock?  And why is it important to stay away from them?

why_you_should_avoid_penny_stocks

How a Penny Stock Scam Works

Back in the days before effective spam filtering through Gmail I would get spam that promoted penny stock investments.  Random emails would come in that read like a (poorly written) press release that specifically highlighted one company and one stock symbol.  Sometimes erroneous or outright fake stock analyst reports would be included with specific price targets.

Of course when you looked up the stock it would be less than $1 per share, often times less than 50 cents per share.  You then compare the current price to the alleged target price… and suddenly you are interested in investing.  (Or so the scammer hopes.)

And it never hurts that this “investing” can only cost you a few hundred bucks thanks to the low share prices.

The scammer has already purchased hundreds if not thousands of shares at an incredibly low stock price in hopes of generating enough interest that a swell of new investors will hop on board, buy more shares, and drive the stock price up.  When you own 10,000 shares and can get the share price to move 50 cents or a dollar, you’ve suddenly made quite the profit.

The scammer then sells all of his shares at the top, and the stock comes crashing back down.

Where are Penny Stocks Traded?

Penny stocks are traded in primarily two places: a stock exchange like the New York Stock Exchange (NYSE) or through an over-the-counter dealer network. The stock exchanges (NYSE, AMEX, Nasdaq, and so forth) are normal places for your equity trades to take place and normally this wouldn’t be a problem.

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The problem is the quality of the stock you are trading.

The second place, the over-the-counter dealer networks, is where things get a bit less comfortable.  OTC stocks are commonly referred to as the pink sheets.  Essentially the companies behind the stocks are either in such bad credit shape that the major exchanges have delisted them or they are intentionally placed there for penny stock purposes.

Speculating vs. Investing

Another red flag of “investing” in penny stocks is you aren’t really investing.  You are speculating.

It is just like buying up a plot of land in hoping there is an oil pocket below the soil; you have no prior knowledge of the situation but will play along to see if you can make it rich quick.

This is quite the opposite of intentional, methodical, researched investing.  You would never set up automatic contributions to go to your brokerage firm and then automatically invested in some random company, would you?  So why are you suddenly interested in dropping a few hundred dollars on thousands of shares of a penny stock company?

It doesn’t make sense.

Investing in Individual Stocks is a High Risk Activity

Furthermore, the simple act of investing in individual stocks is already a high risk activity.

Most individual investors are unqualified to invest in individual issues of specific companies.  Nor do these unqualified investors have the time to monitor all of the news about the company and its industry.  These investors are much better suited to low cost index mutual fund investing; a “set it and forget it” type investment.

Even if you have the time to keep up with individual issues, when you do your research on a prospective company it should steer you away from penny stocks.

And one more thing: most online brokerages charge extra for trading in stocks with a price of less than $5, if they will even let you trade at all.

Final Thoughts

Do yourself a favor and avoid stocks with prices less than $5 unless they are a major Fortune 500 corporation going through difficult times.  (Even then it can be a risky idea.)

There is no need to speculate in shares that trade for less than $1, $0.50, or $0.25.

If you could buy a soda instead of the shares, it probably isn’t a quality company.

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Published or updated February 27, 2013.

Comments

  1. William @ Drop Dead Money says:

    Totally agree. Some of those companies are indeed solid, but the investors they attract just make the chances of coming out ahead so slim as to not be worth the risk. It’s like you said: stocks under $5 deserve extra extra scrutiny.

    That said, I do have this totally awesome stock trading for $4.40 as of yesterday… ;)

  2. A long lon time ago in a universe far away there was a younger version of myself who fell victim to penny stock scams. You have quoted the obvious problems and concerns with penny stocks. The number one thing I would tell people who are considering penny stocks is to name ONE person they know who has gotten rich or earned over $25,000 trading penny stocks. Sure there will be winners but ultimately the majority will be losers.

    • Thanks for dropping by and telling us about your experience with penny stocks.

      That’s the thing isn’t it? You hear these pitches where everyone is getting rich but no one actually sees any real numbers on it. But odds are those that are selling don’t but themselves and they are just salesmen for someone else.

  3. When I work in the enforcement division of the PCAOB we would receive email promoting penny stocks. It was funny that they sent them to folks that regulate public auditors. It was a nice roadmap to fraud.

  4. Aren’t those the worst? My father fell for a penny stock scam back in the 80s and he still talks about it. I don’t really do individual trading at the moment, but I will keep your advice in mind if I start!

  5. Of course here in Canada we now only have nickel stocks, since we got rid of our penny. : )

  6. I always find that scam emails are always poorly written. I bet they’re written by people who’s first language isn’t English. Why would someone want to risk it all in a penny stock, when you can make more overtime with a mutual fund?

    • I’d say most scam emails are poor but there are a few that really look legit. Add to that someone who is hungry to get rich quick and you have a recipe for disaster.

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