Did You Know?
The U.S. Securities and Exchange Commission (SEC) has laid out a set of rules for your dealer/broker that have to be complied with before he/she sells penny stocks to you. Don't forget to read the Section 15(h) of the Securities Exchange Act of 1934 ("Exchange Act") and the rules thereunder before you invest in penny stocks.
Penny stocks are shares floated by small public companies, and are usually priced below $5. They may also include securities that belong to a private company which does not necessarily have a trading market. These low priced and highly speculative securities are not listed on any national stock exchange. They may be traded on the securities exchanges, including foreign securities exchanges. Over-The-Counter Bulletin Board (OTCBB) and Pink Sheets are two electronic exchanges where penny stocks get quoted.
Penny stocks can prove to be more profitable than blue-chip stocks. As these shares are relatively easier to acquire, investors have to watch out for penny stock scams which exist in the market. Because of these and many more reasons, it becomes all the more important that you, as an investor, are aware of the penny stock investment pros and cons before you plan to invest in the same.
Pay less, gain more
Penny stocks are priced below USD 5, and are an appealing proposition for someone who doesn't want to invest huge sums in stocks. Suppose you get 100 shares for $3 each, you will still be spending only USD 300. Just imagine how much money you would have to spend to get stocks of larger companies. Also, it is fairly easy to acquire penny stocks. As you pay less and gain more by buying penny stocks, it is one of the most recommended modes of stock investment.
Unlike blue-chip stocks, as your investment is not huge, the chances of incurring heavy losses is less, even if your penny stock takes a dip. Considering the above example, if you own 100 shares worth USD 3 each, and the stock collapses, even then, you stand to lose only USD 300, and not a hefty amount.
This is one of the key advantages of penny stocks. There have been instances where people have invested in a relatively unknown penny stock, only for it to prosper within a few weeks or days. If the demand for such a stock increases, the price rises even further. Who knows, the price may just go through the roof, and your USD 300 worth penny stock can bring about a hefty profit in the matter of a few days.
Low entry price
Many first time or small investors find investing in larger stocks to be daunting. Firstly, investing in blue-chip stocks require availability of funds as well as the ability to make an informed decision. If you are someone who wants to experiment in the market with a relatively small sum, then penny stocks can be the perfect option. Also, investing in penny stocks with a smaller amount can help you understand the ways of trading in the market.
Higher return on investment
Penny stocks give you an opportunity to invest in a company when it is relatively small. There are always stock advantages if you are with a company right from the beginning. As it grows, you reap more and more benefits. Hence, investing in a good penny stock can help you gain maximum return on investment. You never know which one of your penny stocks, which is a small company today, may turn out to be the next 'Apple' tomorrow.
A different reality
Penny stocks are often floated by smaller companies who are looking for investors. Hence, these stocks do not come with the business and price stability that is exhibited by stocks of established companies. Many companies may falsely 'show' or make 'statements' about a certain venture to boost the prices which may never materialize. Therefore, it is highly advisable that you investigate the company thoroughly before you buy their penny stocks.
One of the biggest drawbacks of penny stocks is that they are highly volatile in nature. Often people invest large sums in penny stocks seeing a trend of rising stock prices, and they anticipate quick and high returns. However, in most cases, the stock fails to rise or collapses the very next day as such companies are generally not well established, reputed or known. The unpredictable or speculative nature of penny stocks makes them a high risk investment option.
Lack of intervention
As the companies offering penny stocks are small public companies which are not listed on any major stock exchanges, a lot of unfair and fraudulent trade practices can be carried out while trading penny stocks. Penny stocks issues by small companies are not governed by any regulatory body and have no obligations to make certain information public, unlike listed companies. Also, there is an absolute lack of any kind of mandatory financial reporting guidelines. You stand the risk of losing out on your investment if the company goes bankrupt. Hence, it is very difficult to adjudge a genuine penny stock from a fraud one.
Unavailability of information
If you want to invest in blue-chip company, you have access to its performance history through previous years financial statements. Also, you have access to information about the stock on various stock exchanges. However, with penny stocks, one cannot be sure if the information about a stock is fake or real. You will have to conduct in depth research to ensure that the penny stock you are investing in is real, and is not part of any marketing fraud.
Pump and dump schemes
There are many manipulators and stock promoters who float pump and dump schemes for penny stocks. Initially they buy a large quantity of a penny stock. Then they resort to artificially inflating the stock prices by sending false positive information about the stock. They also utilize ever means of communication like chat rooms, press releases, newsletters, Internet, email, etc., to reach out to potential investors. The increase in demand further raises the price of the stock. Once a large number of investors buy the stock, these manipulators sell their holdings and make a killing. Needless to say, the artificially inflated price of a stock does not last long and soon hits rock bottom.
Selling penny stocks is difficult
As a responsible investor, your intention is to not only buy the penny stock of a company, but also sell it if you think the time is right. However, penny stocks, most of the time, are traded at lower volumes, and you may find it difficult to get hold of a buyer.
These were some of the pros and cons of investing in penny stocks, also remember that these stocks do not have liquidity and large bid-ask spreads. Moreover, penny stocks are not very popular among mainstream investors, hence, selling them may pose a problem. Apart from that, many penny stock investors may have to deal or face with unfair trade practices and ponzi schemes due to the unregulated nature of such stocks. Hence, you should not trust the claims of a company blindly.