Of all of the stock market urban legends out there, nothing is so highly mythologized as The Legend Of The Person Who Got Rich Off Of Penny Stocks. It’s an enticing story because it allows people to believe that they too can get just as lucky with very little buy-in and low risk. And while that’s sort of true, it’s important to know all the facts about penny stocks before you decide you’re all in.
First, they don’t actually cost a penny: While the Securities and Exchange Commission considers any stock under $5 to be a penny stock, some investors stick to those under $1 per share.
What are penny stocks?
Penny stocks, also known as micro-cap or small-cap stocks, are common shares of small public companies that trade at low prices per share.
Penny stocks might not even be listed on a major exchange like the New York Stock Exchange or the Nasdaq. The reason that these companies aren’t listed on the exchanges is that they usually fall short of the basic requirements to list on a major exchange. Instead, they are traded over-the-counter (OTC for short).
Stocks traded OTC are often those of small or developing companies, but, shares of larger companies can also be traded here. A larger company might find themselves in the OTC market as a result of the company being delisted from a formal exchange or if it is pursuing bankruptcy protection.
OTC exchanges do not have a physical location like the NYSE or Nasdaq headquarters. Actual trades are made by brokers, either by phone or online. It’s essentially just a listing of securities with shares for sale for cheap.
Penny stocks are almost always shares in micro-cap stocks. Micro-cap stocks are shares in companies that have low overall market values of under $10 million and fewer than 500 investors. They could also be small-cap stocks, which are companies with market capitalizations of up to $2 billion.
The “cap” in micro-cap and small-cap is short for capitalization. A company’s market capitalization is determined by its number of outstanding shares multiplied by the current share price.
Are penny stocks risky?
Yes. Because there is a lower volume of trades, penny stock investments are less liquid. Less liquidity increases the chances of not finding a buyer and being forced to sell at unwanted prices. Also, their lower per-share price and smaller market capitalization create an increased risk—not to mention that they’re typically highly speculative, unproven companies.
Since they aren’t being traded on a formal market, they are not required to file with the Securities and Exchange Commission, making the information that is available often less credible. Penny stocks could come from failing companies, or from “companies” that don’t exist at all.
These companies are often the target of buyers who will purchase large quantities of shares, then artificially inflate the price through false and misleading positive statements. This is known as pump-and-dump and is completely unregulated by the SEC—because the companies do not register with them and the shares are bought and sold OTC.
When should you invest in penny stocks?
When you’re fully educated and aware of its inherent riskiness. If the gamble doesn’t scare you away and you’re curious about penny stocks, you’ll need to engage the assistance of a stockbroker to get in on the action. Stockbrokers typically charge a flat fee for trades on top of their commission structure, so be sure to include that in your calculations.
Where can you buy penny stocks?
You can buy penny stocks through an IRL broker or an online platform.
How much should you invest in penny stocks?
Penny stock investing is absolutely considered to be high-risk trading and should be something you do with your “fun money,” not your emergency fund or your retirement savings. Instead of counting on a get-rich-quick urban legend to fund your future, build a diversified portfolio of low-cost investments that grow over time.
Before you invest in penny stocks, or anything, you should establish a mini-emergency fund of around $500 to $1,500. This will go a long way in protecting you from life’s little problems. Because you have this safety net in place, a flat tire won’t cause you to whip out your credit card and go into debt. It’s not just peace of mind, it’s good business. Next, aim to have a big emergency fund that will cover you for three to eight months in a worst-case-scenario situation.
The best place to stash both of these accounts is in a high-yield savings account that allows your money to earn interest—but it doesn’t stop there, eventually, the interest will compound. Compound interest is a magical thing. That’s when the interest you’ve earned on your money starts earning interest itself and then that new interest also starts earning interest and it goes on and on. Welcome to the world of your money making money for you.
Alternatives to penny stocks
Some alternatives to penny stocks are investments made into ETFs, index funds, and mutual funds. These are all a good way to get significant exposure to the stock market at a minimal cost without the stress of picking a “winner” from the penny stocks list.
ETFs, or exchange-traded funds, are collections of securities that you can buy or sell through a brokerage firm on a stock exchange. You can invest in ETFs through Public, either by purchasing full shares or by purchasing slices of ETFs, and to buy and sell is totally commission-free.
Index funds are a lot like a mutual fund in that they are both bundles of investments. Mutual funds are managed by analysts (and therefore cost a premium), whereas index funds are not (and therefore are more affordable). An index fund will invest in companies that belong to particular indexes.
If the main reason that penny stocks appeal to you is their price, you do have options. These days, you can invest any amount of money regardless of the per-share price. Public developed a technology through which stocks can be cut up into tiny bits of a share or “slices.” These slices of stock represent a fixed amount of fractional shares in a single share.
You can still always buy full shares of a stock but if you wanted to buy $5 worth of a stock that costs $800 per share you can make that happen by buying a slice for $5. That fraction of a share remains yours until you sell it.
The bottom line
Penny stocks can be a great way to make money quickly. But they’re also a great way to lose a bunch of money real fast. Franky, the risk just isn’t worth it for most investors. Investing in companies that you believe in, that are regulated by the SEC, might be a better option.