Penny stocks might seem like a great investment for rookie stock investors and traders.
Especially given their price tag and affordability.
But these stocks come with a lot of dangers you may not be aware of.
In this post, we’ll explore what penny stocks are, why they’re dangerous, and what you can do instead as a rookie stock investor and trader.
We’ll also give you some tips on how to invest your money safely and wisely. So if you’re new to the stock investing and trading world, keep reading! You’ll be glad you did.
What Are Penny Stocks?
To understand what makes penny stocks so risky, we first need to understand what they are.
Penny stocks are defined as shares of small companies that trade for less than $5 per share.
They’re often found on the over-the-counter (OTC) market or pink sheets.
If you don’t know what the terms ‘OTC market‘ or ‘pink sheets‘ mean, don’t worry – here’s a quick overview of each…
Over-The-Counter (OTC) Market
The OTC Market is a market where stocks aren’t listed on a major exchange like the Nasdaq or New York Stock Exchange (NYSE). Some OTC stocks might eventually graduate to a major exchange, but most will always trade on the OTC market.
Unlike major exchanges, OTC markets are not regulated as heavily by governing institutions such as the Securities and Exchange Commission (SEC). This means that there’s more room for fraud and manipulation.
Pink Sheets
Pink sheets are similar to the OTC market, but they’re even less regulated. These are typically very small and unknown micro-cap companies (i.e. companies that aren’t worth a lot) that don’t meet the listing requirements of major exchanges.
Some companies might trade on both the OTC market and pink sheets. Others might only trade on one or the other.
Now that we know what penny stocks are and where they trade, let’s explore some of the dangers associated with these types of stocks.
Why Are Penny Stocks So Dangerous? (5 Reasons)
There are a few reasons why penny stocks are so dangerous. Here are some of the biggest dangers to be aware of:
1. Penny Stocks are VERY Volatile
Penny stocks are much more volatile than listed stocks. This means that they can go up or down in value very quickly-often without warning.
This volatility can be a double-edged sword. On one hand, you could see your investment grow quickly. But on the other hand, you could also see it drop just as quickly.
2. They’re Not Regulated as Heavily as Major Exchanges
As we mentioned earlier, penny stocks are not regulated as heavily as other types of stocks. This lack of regulation makes it easier for fraudsters to take advantage of unsuspecting investors. We’ll talk a little more about this in the next point.
3. They’re Highly Manipulated
Because of the lack of regulation involved, penny stocks are often targets for fraudsters and scammers.
Unfortunately, there are many dishonest people who try to take advantage of inexperienced investors by selling them low-quality penny stocks through tactics such as the pump-and-dump schemes.
In a pump-and-dump scheme, someone buys a large number of penny stocks and then artificially inflates the price by spreading false or misleading information about the company. Once the stock price has been artificially inflated, the person selling the stocks “dumps” them, selling them at the higher price and pocketing the difference, while also driving the price down for those who have been misled with false information.
These types of schemes are much more common with penny stocks than with other types of stocks. This is because it’s easier to manipulate a small, unknown company than a larger, more established one.
4. They’re Illiquid
Another danger of penny stocks is that they’re often very illiquid. This means that it can be difficult to find a buyer when you want to sell your stocks – a side effect of no one really knowing about these small companies.
This can be a problem if you need to sell your stocks quickly, but no one is buying. You might be forced to sell at a lower price than you wanted, just to get rid of the stocks.
5. It’s Very Difficult To Research What You’re Buying
Because penny stocks are often small and unknown companies, it can be difficult to find accurate and up-to-date information about them. This makes it hard to make informed investment decisions.
What Stock Investors Can Do To Avoid The Danger of Penny Stocks
Now that you know the major dangers associated with investing in penny stocks, what are some alternative strategies that you can implement as a rookie stock investor and trader?
1. Invest in Larger, More Established Companies
The biggest thing you can do is to stick to larger, more established companies listed on major, regulated exchanges such as the New York Stock Exchange (NYSE) or the NASDAQ.
If you’re not from the United States, you might be wondering if it’s better to stick to exchanges from your own country – and I would say that’s not the case. If you’d like to learn more about why that is, I explain it in more detail here.
2. Do Your Due Diligence / Research
The best way to ensure you mitigate your risk is to research extensively on the stocks you’re interested in buying. As mentioned previously, one of the best benefits of investing in stocks listed on major exchanges is the financial information they are required to release to the public on an ongoing basis.
This makes it much easier for you to find accurate and up-to-date information about these companies. You can then use this information to make informed investment decisions.
If you’re unsure how to do this or where to start, I suggest you either download our FREE 10 Stock-Criteria Checklist or come along to one of my FREE 90-minute Online Masterclasses.
3. Consider Investing in Index Funds
Another alternative strategy is to invest in index funds, which are funds that track an index such as the S&P500 Index (i.e. 500 of the largest US stocks). This is a great option for beginner investors who don’t want to have to pick and choose individual stocks.
One of the benefits of index funds is that they’re well diversified, meaning you’re not putting all your eggs in one basket. This reduces your overall risk as an investor.
Summary
So there you have it. Those are some of the dangers associated with penny stocks. I hope this has given you a better understanding of what to watch out for if you’re considering investing in penny stocks.
Remember, if you’re a beginner investor, it’s always best to stick to larger, more established companies that are listed on major exchanges. And as with any investment decision, make sure you do your due diligence and research before buying any stocks.
Terry
