Beware of Penny Stocks

Jul 23, 2013

To get an enormous stock market gain, buy a penny stock.

To risk losing all of your investment, buy a penny stock. 

Still interested?

Financial commentator Greg Heberlein recommends you steer clear of penny stocks.

When the stock market surges, the greed impulse begins to surface. Investors see portfolio profits expanding and are willing to take more chances. Penny stocks come into view.

What are penny stocks?

For a long time, penny stocks were exactly what they seemed, stocks trading at less than $1. They were also called pink-sheet stocks. That’s because, in the 20th century, listings of low-priced stocks appeared in inches-thick binders of pink sheets of paper. The lists would exceed 20,000 stocks.

All low-priced stocks carry risks. That’s why the federal Securities and Exchange Commission now considers any stock below $5 a share in the penny-stock class. Brokerages will often use the term “penny stock” for those priced under $3. That’s because penny stocks have poor reputations and brokerages don’t want to be seen recommending them.

Penny stocks can be companies that have fallen deeply out of favor. Severe business reversals can be one notable feature; bankruptcy can be another. 

Penny stocks can be companies that don’t wish to make complete SEC filings. They can be companies that don’t meet standards—too few shareholders, total stock value—required for listing on the New York Stock Exchange or NASDAQ.

They can also be shell companies— companies doing no business at all.

Penny stocks are a fool’s paradise

Charlatans have been known to operate penny-stock companies. The pejorative term  “pump and dump” applies to many penny stocks. 

"Pump and dump" is the term for when stock manipulators spread unsubstantiated information to boost a stock’s price so they can sell their shares at higher prices.

Of course, not every low priced stock is a scam or a money vampire.

Sometimes stocks sell at bargain prices and investors reap the rewards when the shares finally take off. As with every investment, do your homework and understand exactly what it is that you're buying.

But if you get an email touting the wonders of a penny stock you've never heard of before, your best bet is to mark it as spam and forget about it.