One of the most frequent questions asked by new investors is related to penny stocks. These are stocks traded on the smaller exchanges or “pink pages”.
Penny stocks can be bought for next to nothing per share, sometimes a fraction of a penny. Investors often think, wow, it couldn’t go lower than that. Trust us… it can, and very often it will.
Let’s start by going through why penny stocks are a bad idea to begin with.
Firstly, they don’t have to comply with the same accounting standards as companies listed on the NASDAQ or NYSE. Often times, companies are penny stocks simply because they can’t comply with these standards or meet the minimum requirements of these exchanges. That’s not the kind of company you should be investing in.
These companies are not covered by Wall Street analysts, meaning there is very little historic or current information available.
Finally, these companies are incredibly volatile. This is what draws novice investors to penny stocks - the potential for massive short term growth. Keep in mind, it works both ways and penny stocks can quickly become worthless.
Penny stocks are highly susceptible to price manipulation. This is where the pump and dump comes in. A pump and dump involves one investor buying up a large quantity of penny stocks. They then spread hype about the company (claiming to have inside information) through newsletters, message boards, cold calling, etc.
Investors start buying (pumping) up the stock, making the price rise and pushing more and more investors to invest. The original investor then sells or ‘dumps’ his large amount of stock and the price plummets.
Penny stocks may seem attractive for young investors, but really they are a complete gamble. Investing in established companies with brilliant track records is a much more secure and lucrative place for your money.