A Penny for Your Stocks

© Can Stock Photo / sqback

Occasionally, you will hear the term “penny stocks” coming up in investment advice. Often this may be in the form of a slick advertisement telling you how much money you’re missing out on by not investing in penny stocks. Unfortunately, in many cases these solicitations are trying to take advantage of you.

What are penny stocks, and why are they so dangerous? So-called penny stocks are stocks that are not listed on any major stock exchange, which typically trade for very low prices per share. In general a company’s share price does not necessarily tell you much about the quality of a company, since different companies float different numbers of shares. But small, unlisted companies generally are not able to circulate useful numbers of shares at anything above a very low price, and typically trade at a few dollars per share or less.

Because these companies float relatively small numbers of shares, they are subject to extreme volatility and their prices may experience very rapid swings up or down. This may not sound so bad on paper (at least the “up” part), but unlisted stocks also suffer serious liquidity risks. Unlike exchange-listed stocks, you can’t push a button and buy or sell penny stocks with an accurate price quote at any given time: over-the-counter stock transactions depend on being able to track down another buyer or seller and negotiate with them. You might buy a stock at $0.20 and watch it go up to $0.30, only to find that nobody actually wants to buy it from you for $0.30. By the time you manage to unload your shares, you may be back down to $0.20 or even lower.

These risks should be enough to warn away most reasonable investors. But on top of that, the structural problems that plague penny stocks also make them an attractive hunting ground for predatory scammers. The classic “pump and dump” scam takes advantage of low trade volumes to easily run up the price with relatively modest stock purchases. The rising price can then be used to encourage victims to buy in, driving the price even higher. At this point the scammer pulls the plug and sells their shares at a profit, crashing the price and leaving their victims holding devalued shares in a worthless company. Any time you hear someone discussing penny stocks, there is a good chance they are either a scammer or a victim who has already been pulled in.

Many such scams have been showing up lately because the scammers have a powerful new bait in the form of cannabis company stocks. The growing trend of state-by-state marijuana legalization has created lucrative new markets that many investors want to get in on, but the continuing threat of legal action at a federal level keeps legitimate finance companies on the sidelines. As a response a number of fly-by-night companies have formed claiming to offer vehicles for individual investors to buy into the growing marijuana market. Be warned: not only could these companies be shut down overnight by federal agencies, many of them are bogus to begin with.

Penny stocks may seem like an enticing way to get in on the ground floor of the next big thing. But companies with the next big thing generally don’t go directly to market—if someone has a great business idea, you can bet it will be snapped up by private venture capitalists. Penny stocks are a minefield best avoided altogether. As always, remember: if something sounds too good to be true, it probably is.

If you hear about a “fabulous” investment opportunity and need help figuring out whether it is legitimate, please give us a call or email us.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Stock investing involves risk including loss of principal.