Why Should You Avoid Penny Stocks?

After the massive success of ‘The Wolf of Wall Street’, many people see penny stocks as a ticket to the big time. In reality, however, they’re more like a quick way to lose a lot of money.

A critical reading of Martin Scorsese’s ‘The Wolf of Wall Street’ would suggest that the real villain of the piece isn’t actually Jordan Belfort. The real villain is us, the viewer that idolizes the alpha-male opportunist who is cheating and stealing his way to the top.

Despite all the warnings the film espouses about the dangers of trading penny stocks, novice investors still swarm to online forums asking where they can get the inside information that will net them quick 2000% returns.

If you’re one of the many who watched the film and didn’t see it as a cautionary tale, read on.

What Are Penny Stocks

Penny stocks are securities that are traded on the smaller exchanges (also known as ‘pink sheets’) which are valued at less than $5 a share.

The reason these companies can’t get listed on the main exchanges is that they fail to meet the accounting standards required by the SEC for publicly traded companies. That should be the first red flag with regards to the kind of companies you want to be investing your money in.

Apple’s financials, for example, have been audited and published for anyone to view. When it comes to penny stocks, it’s practically scout’s honor as to whether the information you’re getting is accurate… that’s if you can get any information at all.

One of our dictums here at Rubicoin is that you should never invest in a company you don’t know. This is even more important when it comes to penny stocks. When you invest in a company listed on the NASDAQ or NYSE, the price you pay for each share is what the market has determined. These stocks have analysts and investors reviewing the company constantly to determine a fair price.

Though the market can fluctuate (sometimes wildly), the price you pay at any given time has been determined by those that have some knowledge of the company, even if you personally don’t.

Another danger in trading penny stocks is the fact that there’s far less liquidity available on the smaller exchanges. That means that when you want to sell your stocks, you might be forced to sell them for well below the market value. This will end up diminishing your returns, or worse—augmenting your losses.

Why Do People Invest In Penny Stocks?

The main draw of penny stocks is their volatility. New investors hear stories posted on web forums about how someone invested a $1,000 in penny stocks and was $30,000 richer the following week.

No doubt that it’s happened. Penny stocks, by their very nature, can see insane growth. But this is also a great reason to avoid them, because volatility works both ways. You may not think a stock valued at 2-3 cents can go much lower, but stock splits can leave these already cheap stocks utterly worthless.

An old sales techniques used by the pink sheet traders is to claim that even Microsoft was a penny stock at one stage. Indeed, if you check a chart you’ll see that back in the late 80s, Microsoft’s stock cost around $0.40. However, that’s not what anyone paid at the time, as the stock has been split 8 times since then.

Finally, penny stocks are highly susceptible to price manipulation. This is where the famous ‘pump and dump’ comes in.

A ‘pump and dump’ involves one investor buying up a large number of penny stocks. They then spread around information about the company, claiming to have inside information. This is done through newsletters, message boards, cold calling, etc. Investors start buying up the stock, causing the price to rise and pushing more and more investment. The original investor then sells, or ‘dumps’, his large amount of stock and the price plummets.

The most famous case of ‘pump and dump’ involved 15-year-old Jonathan Lebed, who circulated newsletters pumping up stocks he owned in 1999. By the time the SEC had caught onto Lebed, he had made close to a million dollars from his bedroom. Having never prosecuted a case against a minor, the SEC struck a deal with Lebed and he managed to keep the majority of his earnings.

(For a more recent example of this highly immoral practice, check out this video from an organization called CryptoCalls. Just try to tell us that’s not a scam).

And So…

The response to this article from penny stock enthusiasts might be that plenty of people do make money trading penny stocks, and they’re right.

However, if you don’t know the market and the mechanics of the smaller exchanges, you’ll end up on the losing side of someone else’s returns.

If you want high-risk, high-reward, focus instead on some small-cap companies that trade on the main exchanges.

Remember, when something seems too good to be true, it almost always is.

 

Demystify the stock market with the free Learn by Rubicoin app, available now on Android and iOS. 

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