Risks to Penny Stock Investments
Investing in penny stocks has many benefits, but there are indeed disadvantages and risks in buying small companies. Most penny stocks did not start out at such low prices; instead, many are larger companies that slowly lost money to the point where their stock prices were beaten down. Others have large debt loads that puts negative pressure on their stock values.
Minimal Public Information
Penny stocks on the big boards like the New York Stock Exchange or the NASDAQ are safer than those listed on the pink sheets because they have to report how their businesses have performed. On the other hand, Pink Sheet companies have to show very little information to their investors, and as such, usually have very thin or no annual report to detail the operations of a company. If you're investing in penny stocks, it would be best to shop for those on the major exchanges that are required to show profits and losses, as well as a general outlook for how the business looks to perform in the future. Investing in penny stocks with little information adds additional risk that isn't needed while giving very little in added returns. Stick with the big boards and watch your penny stock investments perform very well.
They're Very Cheap
Because penny stocks are so cheap, they can't move like they would if they had valuations of $10+ per share. Mutual funds generally have a rule that keeps them from buying stocks that trade for less than $10 per share, and thus, cannot give positive momentum to penny stocks. Likewise, very few analysts are willing to cover penny stocks because the audience for their analysis is generally very small. Small changes of one or two cents can be a 10 to 20% move.
Stock brokers generally let you trade up to 5000 shares with zero extra commissions; after this point, you usually incur an additional half cent or cent per share over 5000. To buy a big position in a penny stock, you're likely to pay much more than you would have expected to complete the trade. Larger commissions means smaller profits and a degradation of returns over long periods of time.
Penny stocks have generally low volume because the number of investors trading them is small. Because of this, buying into a penny stock may mean that you'll push the price upwards just to get in, and even then selling your penny stock shares will flood the market. Large volume orders move the market; try to avoid penny stocks with low daily volume. Liquidity is key when buying into penny stocks.
The Majority Fail
The majority of penny stocks do ultimately fail, which can make investing in penny stocks a very emotional ride. If you're losing 9 out of 10 trades but getting a big winner in between, you'll be doing well, but the toll of seeing an account balance fall so greatly can really weigh in on your trading psychology. Only invest in penny stocks if you have the right attitude and enough money to ride through the storms.