Tuesday, July 26, 2011

The (Dis)Advantages of Buying Penny Stocks

I happened across an ad claiming that “Penny stocks are the secret to buying happiness during a recession.” I couldn’t resist having a look. The link took me to an “advertorial” by SmarterLifestyles entitled “The Advantages of Buying Penny Stocks.” (I prefer not to give the link, but determined readers can search.) The article contains a number of misconceptions about penny stocks.
“Penny stocks offer an incredible upside for potential investors.”
They also offer incredible downside. That’s the nature of highly volatile investments.
“Low prices allow novices to explore the markets, without risking an extensive amount of money.”
Nonsense. You can just as easily buy one share of a $100 stock as 100 shares of a $1 stock. Either way you’re investing $100. I don’t recommend either investment because the commission (likely $5 or $10 or more) is too pricey for such a small investment.
“If the stock were to dip in price, the investor will not have lost excessive amounts of money.”
More nonsense. If you’ve invested $100 and the stock goes down 50%, you lose $50 whether you have one share that dropped from $100 to $50 or 100 shares that dropped from $1 to $0.50.
“Another advantage to penny stocks is that they are easy to buy.”
Penny stocks are no easier to buy than “regular” stocks.
“The biggest advantage is the potential for very high returns on investment.”
There is also the potential of very high losses. Unfortunately, high volatility is bad for long-term returns.
“It is not uncommon for some penny stocks to double or triple in price in extremely short periods of time.”
It’s also not uncommon for penny stocks to drop to near zero in extremely short periods of time.

People tend to like penny stocks because they seem cheap, but this is an illusion. Companies divide their ownership in some number of shares. The number of shares is quite arbitrary. If a company is worth $100 million and has a million shares, each share is worth $100. The company could just as easily issue 100 million shares so that each share is worth only $1. Don’t be fooled into thinking that penny stocks are a good way to put your toe into the stock market.

8 comments:

  1. Easier to buy?? I'd say if anything they're more difficult: many have poor liquidity, spreads can be high (esp. as a percent of price: bid .10 ask .11 is a 10% spread, vs. bid 50.01, ask 50.02), and if they get delisted it only gets more difficult.

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  2. @Potato: As long as you're willing to accept any price, I'm sure that trading penny stocks is as easy as clicking a button. But as you say, trying to get a fair price can be very difficult.

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  3. Yah I have a friend that won't buy LULU because he feels it is too high priced. He'd rather buy some little name he knows little about because it is "cheap.". Go figure. Meanwhile LULU continues to climb.

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  4. Reminded me of a claim I saw one time that even MSFT used to be a penny stock. Not true, it just appears it was once a penny stock by looking at historical prices. Each share was split so many times, the historical prices per share are in penny stock territory.

    Another possible drawback is that penny stocks were probably once $5 or $10 stocks, but they are of such low quality they've lost 80% or 90% of their value.

    Potato makes a good point about spreads.

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  5. @Gene: I've heard that story about MSFT being a penny stock at one time as well. It's hard to blame a novice for believing it.

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  6. You need a good broker who specializes in penny stocks and gives you great advice on penny shares and investing, rather than a stockbroker just to place an order for you.

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  7. Meanwhile LULU lost 19 % since Doctor Stock published his post!

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  8. @ Anonymous - Any and every stock has it's cycle. Entering in a technical points based on the weekly trends is the key to success. What I've found is the larger names tend to be more "predictable" in their action... which is why I just sold LULU this past week for a 20.5% profit (I did not purchase or advocate purchasing LULU on July 26th)... in fact, I was positioning my stop losses for a sale. Nevertheless, I'll continue to look to these types of stocks, rather than the penny stocks, for predictable profits. It's just my preference, not the way it has to be for you :).

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