Penny stocks attract plenty of investors. If you buy the right penny stocks, you can get handsome returns. Unfortunately, it is also easy to lose money on penny stocks. Here is an overview of penny stock advantages and disadvantages.
For many people penny stocks are shares that trade at low prices, typically less than two dollars. In the US, the SEC defines a penny stock a share that sells for less than $5. The SEC also requires that the share is not listed on a national stock exchange plus some additional criteria. In the UK, shares that trade for less than £1 called penny shares.
So why are penny stocks attractive as investment? The two main reasons are that penny stocks are often very volatile, the movements in percent can often be large, and most penny stocks are micro cap stocks which means that successful companies can grow a lot.
Despite the fact that penny stocks are cheap, penny stocks can still go down in value. The big price changes, measured in percent, can go in both directions. Unfortunately, the spread for many penny stocks can be big. This means you may need a relatively big gain before you are making a profit.
Studies has shown that over longer periods of time, small caps perform better than large caps. Cap refers to market capitalization, which is the total value of all outstanding shares. The share prices of large caps, that is companies with large market capitalization, are typically less volatile than for small caps. But that does of course not mean that all small caps perform better than large caps. Indeed, most small caps stay small. But a few successful companies managed to grow tenfold, yes even hundredfold or more. If you can find such winners, you can make a lot of money.
But there are also a number of disadvantages with penny stocks. As mentioned earlier, the spread (the difference between the bid and ask price) can be fairly large. One reason for this is that many penny stocks are illiquid, meaning that the number of transactions is low. This also means that it can be difficult to quickly buy or sell specific penny stocks.
The main drawback with penny stocks in the US is the lack of regulations. This means that the risk of price manipulation is much greater than for shares traded on for example the NYSE. The fact that many penny stocks are thinly traded also makes it easier to manipulate the price.
One thing to remember about small companies is that while large companies once were small companies, not all small companies managed to become large. On the contrary, a lot of small companies remain small or go bankrupt. Sometimes you hear the argument that all large companies started as small companies so by investing in penny stocks you get the chance to invest early in the next Walmart, Microsoft or Cisco. But that has not much with reality to do, most of the large companies were already far beyond the micro cap level when they went public. And the share price when they went public was not just a few dollars.
Another thing well worth remembering is that there is generally a good reason for why the share price is low. Typically, the share price has been much higher but the company got into trouble and the share price plummeted. A successful penny stock investor must be able to judge how likely it is that the company can solve its problem.
So is it worth investing in penny stocks? Yes, it can be but beware that it is probably more about speculation than investing. Often it can be difficult to value a penny stock, there is simple not much reliable information. Even worse, hot penny stocks are often very highly valued. But yes, as long as you are aware of the risks with penny stocks, it is nothing wrong having some penny stocks in your portfolio. After all, if you get it right, you can make good money. Just remember that penny stocks are not as safe investment as large caps.