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Sometimes, the world of investing can seem impenetrable to people who do not have a background in finance. Individuals who want to get started in investing can minimize their risk while learning about the stock market by purchasing so-called “penny stocks,” which are small-cap stocks at low prices. Despite the name, virtually no penny stocks actually cost a penny. Instead, they are typically stocks that are traded for less than $5 per share. Stocks listed on the New York Stock Exchange (NYSE) are not typically considered penny stocks, even if they cost less than $5. For this reason, many experienced investors tend to ignore these stocks. Unfortunately, penny stocks can also be associated with scams and corruption, so individuals still need to do their homework before they start investing.
For the novice investor, penny stocks hold a lot of allure. Since they often cost less than $1, individuals can easily purchase hundreds of shares, which have the potential for major payoffs once the stock rises in value. However, individuals need to understand that penny stocks are speculative and high risk because of their lack of liquidity and small market capitalization.
Purchasing Penny Stocks
Even though they are not listed on the major exchanges, penny stocks are purchased through normal stockbrokers, just like with any other stock. The most common listing services for penny stocks include Pink Sheets and Over-the-Count Bulletin Board (OTCBB). Pink Sheets is simply a quotation publisher, meaning that it has no listing requirements. OTCBB, on the other hand, does have listing requirements, even if they are fairly lax, so some investors consider it more legitimate. Pink Sheets is not registered with the SEC, but OTCBB is, so investments with the former carry greater risk.
The reason that cheaper stocks traded on NYSE and NASDAQ are not considered penny stocks is due to the stringent listing requirements of these major exchanges. Thus, they carry much less risk and can be a good option for more risk-adverse investors. However, less risk also means less chance of a payoff.
Why Penny Stocks?
Since penny stocks have a lot of risk, why would novice investors choose to purchase shares? The answer is that penny stocks have a lot of excitement and teach some important investing lessons without the need for high stakes. Individuals should only invest a limited amount of money until they feel more comfortable with the risk that these options pose. The opportunity for high payoff comes from volatility. Experienced independent investors often purchase shares at $0.08 in hopes that the stock will rise to $8 within a matter of weeks. While this may seem like wishful thinking, it has happened.
One notable young man began investing in penny stocks with $1,500 and developed a portfolio worth $1 million in only three years. The chance of such a high payoff is what motivates novice investors and gets them excited about getting more involved in the stock market.
The Major Risks of Penny Stocks
The biggest problem associated with penny stocks is their lack of liquidity. Once people purchase the stocks, they may have trouble selling them because they trade so infrequently. Also, it can prove difficult to find quotations for a given penny stock, which renders accurate pricing impossible. Before purchasing any penny stocks, individuals need to understand that they could end up with worthless stock that no one wants to purchase.
Penny stocks tend to attract dishonest business owners because companies can continue to sell equity even if they are delinquent in submitting filings to the SEC. For this reason, the SEC has taken some major steps in protecting consumers from such companies in the penny stock arena. In fact, brokers are legally required to send a document outlining the risks of penny stock ownership before brokering a sale. Novice investors should not let this information scare them away from investing. The risks of penny stocks are much higher than with traditional stocks, but the low prices mean that the stakes are lower as well.
Picking the Best Penny Stocks
How do investors keep from losing out in the penny stock arena? The secret is to conduct even more research than one would with traditional stocks, which is ultimately what makes penny stocks such good practice for transitioning to the major exchanges. Individuals need to pay special attention to the underlying business of any penny stock and be sure to avoid shell companies that are legally incorporated and are selling stocks but do not actually have any business operations. All companies should have real and sustainable business operations verified by first-hand investor research.
Individuals should pay special attention to company finances. With traditional stocks, the question is how much profit the company is turning. When it comes to penny stocks, investors pay more attention to the quality of financial statements. Honest companies file their statements on time and work with quality auditing firms. Of course, the financials should also look healthy and sustainable. Footnotes in financial filings are usually ignored, but they can bear extremely important information for penny stock companies.