Why You Might Be Worse off With Even the ‘Best Penny Stocks’

Ever considered buying penny stocks? Make sure you know the risks and other options available to you before you invest your money.

Written by Caish Echols AFC®, CFP® / October 6, 2022

Quick Bites

  • When it comes to investing, if it sounds too good to be true, it probably is.
  • Penny stocks are a very risky type of investment.
  • Before you invest, you need to have a plan or purpose behind what you want your money to do.

If your friend told you they were going to Vegas to gamble in order to make money to pay their bills, would you think it was a good idea? I bet not. Most people who want to earn an income choose to get a job and pursue a career—or start a business—because it’s a more sure-fire way to have money coming in consistently. At least, more sure-fire than speculating.

When it comes to investing, similar principles apply. Even though investing is riskier than simply earning a salary (because the returns are never guaranteed), there are some investments that tend to be safer while others are more high-stakes. One of those riskier investments are penny stocks.

Inside this article

  1. What is a penny stock?
  2. Why are penny stocks risky?
  3. First, set your investment goals
  4. An alternative to penny stocks

What is a penny stock?

A penny stock, or microcap stock, is a stock from a relatively small company that trades for a low amount (usually $5 or less per share). These stocks are sometimes traded on the normal stock exchanges, but most of the time they trade on the OTC market, or “over the counter.”[1]

A lot of people get excited at the prospect of trading penny stocks because they know of companies who began as penny stocks and then grew into huge successes. You’ve probably heard of someone who got rich “investing in the early days” and maybe you’ve hoped you could have the same luck. The problem with this mentality is that for every Amazon-like company there are thousands (if not millions) of other companies that started as penny stocks and ended as an investor’s nightmare.

Why are penny stocks not a good idea?

Think of penny stocks like the lotto tickets of investing. Although inexpensive to buy, they’re unlikely to produce a large financial gain.

Most people know when they buy a lottery ticket that the odds of winnings are astronomically low. However, when it comes to people investing their money in penny stocks, many think they are going to make it big. It’s important to realize that buying lottery stubs and penny stocks are both speculative investments.

So what is it that makes buying penny stocks so much riskier than typical stock trading? The U.S. Securities and Exchange Commission (SEC) has outlined five reasons these microcap stocks tend to be so risky[2]:

  1. There isn’t a lot of public information available regarding the companies that issue the penny stocks because they are so small. This makes it hard to determine the likelihood of company success and the true value of the stock.

  2. There are no minimums in regard to the number of shareholders or net asset value of the company.

  3. Penny stocks are less liquid than typical stocks, making them harder to trade.

  4. Their prices are constantly in flux. This high volatility can lead to big financial loss.

  5. Because of these other four reasons, they are highly susceptible to fraud. Many investors have been scammed by purchasing penny stocks in the past.

Everyone should consider these risks before buying penny stocks. In my opinion, these risks outweigh the likelihood of a positive financial upside. And, quite frankly, it seems like a gamble.

So what other options are there if you want to start investing but don’t want to take on that much risk?

First, set your investment goals

The first thing you want to do before you spend your hard earned money is have a plan specific to you and your goals.

A lot of times, investment losses, whether from penny stocks or not, come about because people invest without a clear picture of what they’re investing for and how much risk they’re willing to take to get there. If you hire an investment advisor they are required to complete an investment policy statement (IPS) for you. This document spells out…

  • How much risk you’re willing to take

  • Which types of stocks and bonds you’re comfortable investing in

  • What you’re investing for

  • How long you plan to invest

Tip: If you’re investing without the help of an advisor, make your own IPS. Once you’re clear on your goals and the risk/reward trade off you’re willing to take, it’s easier to know whether penny stocks or any other investments fit into your plan or not.

My personal investment philosophy is a conservative one and can be summed up in a few bullet points:

  • I don’t like to take on more risk than I have to

  • I buy low-cost index funds

  • I’m investing to make work optional in the future

  • I plan to keep my money invested for 20-plus years

Knowing all this has allowed me to develop a passive investment approach that works for me and my goals. If your IPS sounds similar to mine, you might consider buying low-cost index funds instead of chasing penny stocks or other risky investment schemes.

Consider this alternative to penny stocks

A low-cost index fund is a type of mutual fund. When you buy a mutual fund, you purchase one fund and then your money is pooled with others who also bought the same fund. A mutual fund manager then uses the pooled money to purchase a variety of different stocks and/or bonds that align with the goal of the mutual fund. Mutual funds are nice because they are an easy way to invest in multiple companies or areas of the stock market all at once.

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The different costs that go into managing the mutual fund make up its expense ratio. The lower the expense ratio, the less you pay to own the investment. An index mutual fund has the goal of tracking an index, like the S&P 500. This requires less work on the part of the manager meaning they have lower expense ratios, and their returns mimic the index they follow. I like low-cost index funds because the returns are similar to the rest of the stock market, but they don’t involve me taking on extra risk or paying hidden fees.

Although it doesn’t sound as exciting, buying low-cost index funds feels like the “earning a salary” equivalent in investing—it’s less flashy but more secure. It may be a good option for you too if you want investments you can “set and forget” rather than worry about and chase.

No matter what you decide to invest in, be clear about your goals. And if, after learning about all the risks and alternative ways to invest, you decide you still want to buy penny stocks, make sure to follow the recommendations by the SEC to look for red flags and do your research beforehand.

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Article Sources
  1. “Microcap Stock: A Guide for Investors,” SEC.gov, Sept. 18, 2013, https://www.sec.gov/reportspubs/investor-publications/investorpubsmicrocapstockhtm.html.
  2. “Investor Bulletin: Microcap Stock Basics (Part 3 of 3: Risk),” Investor.gov, Oct. 21, 2016, https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/investor-2.

About the Author

Caish Echols

Caish Echols AFC®, CFP®

Caish has worked in the financial planning industry for over 5 years, including working for one of the pioneer financial planners who brought fee-only financial advice to Millennials. She loves making the complexities of finance simple to understand and helping people follow their own paths.

Full bio

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