Penny stocks are highly speculative investments, and traders should be careful when dealing with them. But why do penny stocks exist if they can be so dangerous? We dug deep into this question and came up with some answers below.
About Penny Stocks
Any stock trading below $5 per share is typically termed a penny stock. In most cases, these are shares of small companies with a low market capitalization that is traded infrequently.
They are sold through either the OTC bulletin board or a privately owned OTC markets group instead of on a major stock exchange.
However, remember that not all OTC stocks are penny stocks. There are some international shares that are also traded on these markets.
Why Do Penny Stocks Exist?
Penny stocks are a way for small businesses to raise capital to fuel their future plans. When a business venture starts out, it is hard to raise money because the model needs to be proven.
Listing it on the stock market is one way it can be done. Other possible options are raising debt or getting venture capital.
Unfortunately, getting a loan might be prohibitively expensive for startups. At the same time, venture capital is hard to get and comes with several riders.
Listing the firm at a low price is a way for such companies to raise money through small investors instead.
These folks are willing to believe in the business and hope to see it grow, and it can be a win-win for both parties.
This route lets founders get the money they need to execute their business strategies. On the other hand, investors might see strong capital growth if the business starts to do well.
For example, the early investors in firms like Amazon and Microsoft would have bought these shares when they might have been penny stocks or very low-priced stocks.
Think of the exponential capital growth they would have seen over the years.
It is important to note that buying penny stocks may not always pan out. For those who buy penny stocks, they are high-risk, high-reward bets.
Why Are Penny Stocks So Cheap?
Penny stocks are cheap because they belong to small companies that are trying to grow their business and do not have a proven profitability model.
That said, investors may prefer to avoid paying high prices for such stocks.
But there are other factors at play as well.
Some businesses might want to keep the stock price low to entice buyers to invest more in them.
A company’s valuation depends on the stock price and the number of shares traded. For example, a business with a million-dollar valuation could list its stock in many ways:
- 1 million stocks for $1 each
- 10,000 shares, each one for $100
- 100 securities, each worth $10,000.
If you notice, the first one of these is a penny stock; the other two are not.
So, what constitutes a penny stock also depends on how the company prices its share.
Related: Penny Stocks That Could Explode!
Do Most Penny Stocks Fail?
Yes, most penny stocks fail. Many of these companies have poor financials and untested business plans, which is why they are selling at such low prices in the first place.
Moreover, these securities often trade on over-the-counter markets rather than through a recognized stock market like the New York Stock Exchange.
The penny stock market has lower regulations and is not controlled by the Securities and Exchange Commission.
Companies listed here do not have to regularly declare their financials and other information.
This lack of transparency often lets penny stock companies hide poor performance.
In fact, some of these shares exist simply so that the company’s promoters can make money by ripping off buyers using pump-and-dump schemes and other scams.
While, in theory, even a penny stock can become a multi-bagger, the sad truth is that such cases are rare.
Can I Get Rich off Penny Stocks?
Yes, it is possible to become rich off penny stock investing. However, it is quite unlikely that one can get rich purely through this method.
An SEC report on over-the-counter markets (where most such securities trade) shows that the median investor loses money on penny stock trading.
There is a certain attraction to anything available for cheap. However,these stocks are volatile and have few shares available to trade in the market, which makes them susceptible to fraud.
Since their prices fluctuate significantly, it is possible to make wild gains in penny stock investing. However, losing your money on them is equally likely.
Related: How to Evaluate Penny Stocks
Are Penny Stocks Ever Worth It?
In most cases, buying penny stocks is not worth the risk for small investors.
While it is possible to make money from them, it takes a lot of skill and risk-taking ability. Unlike regular stocks on major stock exchanges, penny stocks trade on OTC markets (or throughpink sheets).
Since they are unregulated, such micro-cap stocks have little information available to study them. Potential investors do not get crucial details about business quality and performance through regular financial disclosures.
This is why most investors tend to stay away from them.
Related: Why Do Penny Stocks Fluctuate?
Do Penny Stocks Ever Recover?
Yes, penny stocks can recover and grow back again. There are a few companies whose stock has fallen into penny stock status but recovered later.
For example, Ford Motors fell twice to below $5 prices in 2008 and 2020 but came back up again and is not trading as one now.
AMD is another stock that has done this multiple times.
Should I Invest in Penny Stocks?
You can invest in penny stocks, but should do it only if you have a high risk appetite and can do the due diligence needed to pick winners.
The penny stock market is rife with scams and rip-offs. Investors should avoid “rumors” and trade only in securities with adequate information.
A few stocks may have fallen in value to become penny stocks temporarily, and such securities could be potential winners. But it requires a lot of study to identify them.
There might also be some excellent startups in the penny stock markets Finding them is only possible with a comprehensive analysis of their sector, risks, and future prospects.
Lastly, one should invest in more than just penny stocks. Limiting them to less than five percent of your portfolio is a good idea.
Why Shouldn’t I Invest in Penny Stocks?
Trading penny stocks is a highly speculative investment that requires a large risk appetite. This is why most folks should not invest in them.
Several scams, misinformation, and rumors exist in these markets. Most such stocks have a low float (number of stocks available for trading) and low volume (number of transactions).
This makes them easy targets for several types of securities frauds.
Final Thoughts
Penny stocks exist because there are many small companies looking to raise money through retail investors who use this route.
Their existence helps the economy, the investors, and these businesses by giving them a chance to let them grow.
However, most penny stocks are not traded on major market exchanges and have low stock volume and poor stock float. This makes them a risky proposition.
Penny stock investors should evaluate each opportunity carefully and ensure it is not a scam before investing their hard-earned money.
It is possible to become rich on penny stocks, but it is highly unlikely because of the huge risk involved. Limiting exposure to these highly volatile financial instruments in your portfolio is best.
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