It’s easy to get sticker shock when you realize just how expensive popular stocks have become. Investing in Amazon or Google’s parent company, Alphabet, might cost you all your money to only buy one share, after all. Not everyone has the means — or the nerve — to invest so much money into a single investment.
What is a penny stock?
On the other end of the spectrum are penny stocks, or stocks that trade for less than $5 a share. Most penny stocks actually cost less than $2 a share, but the rule isn’t set in stone.
Most companies that offer penny stocks are fairly new and haven’t quite established themselves as a successful business. This makes them highly speculative for investors, which is obviously reflected in the cost for a share of their stock.
Also note that penny stocks don’t trade as much as other stocks, nor do they normally trade on major market exchanges. Most companies that offer penny stock aren’t transparent enough about their financials to exist on a major exchange, nor do they adhere to the strict requirements they employ.
Can you make money with penny stocks?
According to Chris Ball, a financial advisor and the founder of Build Financial Muscle, you can absolutely make money with penny stocks. In fact, the potential for profit is really the main incentive that draws people in. Not only do penny stocks allow you to invest in companies that are poised for significant growth, but you can often by a large sum of shares for very little.
Good penny stocks also tend to move up in price quickly, he says. For that reason, “people who are willing to do homework on the companies and are not easily swayed by volatility can do well.”
The key to ending up ahead with penny stocks is the same rule that guides the investing world — buy low and sell high. For example, you could get in when shares are .10 cents each and they could rise to $2 apiece. Buying 500 shares will only cost you $50 and you’d earn $1,000. Imagine what you could’ve earned with 1,000 shares or more. But this only works out if a company actually performs well.
Taking a chance on a penny stock is like playing a slot machine — you have a feeling you might win big without really knowing what it’s capable of. If you know the market and company well, you might believe a certain penny stock is worthy of your money. If you can handle high-risk investments — and can stand to lose the cash if it doesn’t work out — then penny stocks could work for you in the long run.
Are penny stocks illegal?
Penny stocks aren’t illegal in the slightest, although they are commonly used in a variety of financial scams. For example, many penny stocks get used for a “pump and dump” scheme, meaning a group of investors will artificially inflate the price only so they can sell their shares and walk away. Other companies that trade in penny stocks are predicated on false information and fraud to begin with.
Also remember that penny stocks let you invest into companies without a proven track record. As such, you may never see your money again.
Companies that trade in penny stocks aren’t on major market exchanges, don’t bring in a lot of profit, and have limited operations and resources. It’s hard to know if a company will succeed if you don’t know enough about them to predict their success.
The Security and Exchange Commission (SEC) usually regulates companies with more than $10 million in assets and more than 500 registered shareholders, so most penny stocks aren’t required to file financial statements. This leaves stockholders (and potential stockholders) to invest blindly.
As a result, the SEC considers penny stocks “speculative investments” where buyers should know the full risks before ownership.
“Investors in penny stocks should be prepared for the possibility that they may lose their whole investment,” the SEC says. “Or an amount in excess of their investment if they purchased penny stocks on margin.”
What to look for in penny stocks
When it comes to finding penny stocks to invest in, ample research will likely be the key to your success. If the goal of investing in penny stocks is buying stock in companies that are getting ready to become wildly profitable, then you need to know how to search for this information.
While you may not love this advice, your best bet is keeping up with the financial stats and emerging news of companies that trade in penny stock. Believe it or not, you can find out a ton of financial information about small companies on websites like Yahoo Finance or Google Finance.
For the most part, you’ll want to search for the following types of companies:
- Companies that are just starting out but hold promise thanks to an inventive idea of clever business plan
- Companies on the verge of announcing a profitable partnership or endeavor
- Companies that have strong fundamentals and the ability to compete in their industry
In addition to conducting your own research, find someone who knows the industry well and ask them to mentor you on how to find the best penny stocks for maximum return. You will be much better off if you are able to learn from someone else’s mistakes instead of making them all on your own.
The cons of penny stocks
Researching penny stocks to see if you can learn to spot a winner is one thing, but actually investing your money is another. Before you throw your hard-earned cash into a speculative investment, it’s crucial to understand the worst case scenario.
The most important detail to understand is that penny stocks are extremely risky, says Ball. “A lot of the companies are penny stocks for a reason,” he says, adding that they are often “low quality companies who are potentially ready to disappear.”
Many people who invest in penny stocks lose their money altogether because they don’t have the knowledge, experience, or patience to make this strategy work.
“Penny stocks can be a tool for shady stock trading activity, leaving you with nothing,” he says.
Brandon Renfro, a financial planner and assistant professor finance at East Texas Baptist University, also points out that penny stocks can be especially risky for those approaching retirement age.
“The volatility and likelihood of failure are both too high to reliably provide a capital base from which to take an income,” he says. And that’s why he says that retired investors who are making withdrawals on their accounts “should especially avoid penny stocks.”
How to get started
Renfro still says that, despite their downsides, penny stocks can be an okay option for a certain type of investor — namely, those who have a very high tolerance for risk.
Still, it’s pretty common for new investors to try their hand at penny stocks without diving right in at first. In other words, most start by paper trading — as in, they pretend to buy and sell penny stocks on paper to get a hang of it. This allows investors to experiment with penny stocks and perhaps learn the ins and outs of the industry without putting any of their money at risk.
Once you’re ready to give penny stocks a real chance, creating an account to start investing is easy. Most of the major online stock trading websites let you invest in penny stocks, including popular options like E*Trade or TD Ameritrade.