Penny Stocks (stocks that trade for less than $5.00 per share) are, for some people, an exciting investment. Because Penny Stocks are so “cheap,” many people mistakenly believe that they are more likely to be bargains. The reasoning is simple: they can cap losses at less than $5.00 per share, but their upside is unlimited.
This may sound appealing, but in reality, it is a dangerous line of reasoning. Penny stocks are far from a sure thing. Remember, there is a reason that the stock price has dropped so low. The company may have a high debt load, or corporate management may have guided the enterprise down the wrong path. Whatever the reason, other people (including professional investors) have acknowledged that the company is high risk, and have punished shareholders by driving down the stock price. It is always important to keep this in mind.
There are other considerations associated with penny stock investing besides the risk factors. One of these is the cost of trades. Trading costs (as a percentage of the total trade) tend to be above average for penny stock orders. Let’s say I buy 100 shares of a penny stock at $1.00 per share. The total cost is $100, and I pay a $10 charge for the trade. My trading costs are 10% of my total investment. In this situation, the trading costs can have a significant impact on your expected return. But let’s say that instead, I buy 100 shares of a more established stock for $50 per share, for a total investment of $5,000. Now my $10 trading cost is only 0.2% of my total investment. Simply put, you can reduce your overall trading expense by minimizing your exposure to penny stocks.
Finally, penny stocks often carry the risk of less public information. Many penny stocks are specialized companies that conduct proprietary or discreet operations. This is not necessarily a bad thing, but it does create a challenge in evaluating the company. Not having a clear understanding of a business model makes it much harder to invest intelligently.
While it is true that some penny stocks may be good opportunities, they are generally not appropriate for an inexperienced investor. If you do choose to invest in penny stocks, make sure to understand the risks and additional costs, and do your homework. Most importantly, do not invest more than you can afford to lose.