- Penny stocks trade at a very low price with a small market capitalization and are generally preferred by investors with a high-risk appetite.
- Through penny stocks, investors can make massive gains and run the risk of making significant losses in a short period, given the volatile nature of these stocks.
- Apart from the unpredictability, insider trading risks, lack of available historical data, and involvement of manipulators are some of the other reasons that can push investors away from penny stocks.
Penny stocks trade at a low price (under $1) and market cap less than $300 million. However, in the US, the US Securities and Exchange Commission modified the definition of penny stocks and included all stocks that trade below $5. These stocks are primarily illiquid and trade on large exchanges via OTC transaction.
Penny stocks are generally linked to small companies and trade occasionally. The holder of these stocks finds it challenging to sell the stocks. This is due to either a lack of liquidity or buyers unwilling to purchase these stocks. Besides, these stocks have low liquidity, and thus investors might face a challenge in finding the price that reflects the market correctly.
Through penny stocks, investors can make massive gains and also huge losses within a short period. Hence, these stocks are preferred by those investors who have a high-risk tolerance capacity.
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Why do people suggest not to buy penny stocks?
We are aware that penny stocks are risky. However, there are a few other reasons which make investors think twice before looking at them.
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- The Company's size: Penny stocks represent very small companies, and their stock gets influenced significantly when the business performs well. On the other hand, if the business does not perform well, there are chances that investors can even make huge losses.
- Penny stocks can influence investors: Penny stocks are less likely to attract trade on the exchange. Thus, it becomes the target of manipulators. Even if there is a small buying of the stocks, one can see a huge boost in the share price to extreme levels. This price movement attracts other investors to put their money with the intention to make a huge profit. However, if the seller sells the stocks at a higher price, other investors in the market holding these particular stocks might make huge losses.
- Limited scope of Research: Research is an essential part of stock analysis process. While studying a particular stock, an analyst looks into parameters like fundamentals, technical, financial numbers, management of the Company, news, and announcements. As penny stocks are a small-size business, there are high chances that the data available to the public is limited and they have limited data to research on the stocks. Even the data available to the public could be manipulated or sometimes hidden.
- Chances of insider trading: As penny stock companies share limited information with the public, there is a considerable scope of insider trading. There are chances that the promotors or other direct investors start manipulating other investors.
- Harder to buy and sell: Major stocks have many investors who buy and sell the stocks on any given day. However, in the case of penny stocks, there are possibilities that these stocks might not have many shares of their shares outstanding. There could be occasion when there are no shares of these penny stocks to trade. Hence, in such a case, if a buyer is ready to purchase stocks, they might not purchase as no seller is selling the stock. Also, if the seller is ready to sell, no one is ready to purchase the shares. In this condition, the seller could be stuck here.
- Lack of historical data: In penny stocks, the companies could be either newly formed or possibly are in the bankruptcy stage. The companies which are newly formed have little or almost no historical data to show. Hence, one cannot easily assess the potential of the stock based on past data. On the other hand, the companies in the bankruptcy state would have a poor track record or sometimes there is no track record.
The reasons highlighted above compel individuals to stay away from penny stocks.
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Alternatives for long-term investment
Undoubtedly, penny stocks provide investors with huge return, but at the same time, they carry huge risk. Hence, investors with a lower risk appetite or less experience in the stock market look for alternative ways to invest for the long term.
Experts always suggest people invest as per their goals. For this, a person can seek guidance from advisors who can support in coming up with a specific plan based on the existing situation.
In general, every investor should follow the following two guidelines:
- Diversification of portfolio
- Focus on low-cost investment