Why Are Penny Stocks a Bad Idea? Explained

    There seems to be a lot of misunderstanding regarding penny stocks, and how they can be considered a bad idea for most investors. Are penny stocks a good investment? Are they really worth the risk?

    In this article, we will see why penny stocks are a bad idea for most investors, as they carry too many risks.

    Why you should not invest in penny stocks?

    Penny stocks are a much more risky investment than stocks traded on major exchanges. They carry more risk and have several disadvantages when compared with other stocks.

    Let’s look at some of the biggest risks associated with penny stocks:

    • High volatility
    • Low liquidity
    • Low trading volume
    • Wide bid-ask spreads
    • Less information available
    • Easily manipulated
    • More prone to scams
    • Unproven business models
    • Difficult to value 
    • No analysis of the company
    • Difficult to estimate returns
    • No analysts covering the stock
    • No analyst estimates
    • Higher fees
    • Lack of financial statements

    High volatility

    Since penny stocks have small market caps and have very low stock prices, they are more volatile than traditional stocks. This means that the price tends to move incredibly fast, either up or down.

    This is a common risk with penny stocks, and one of the reasons inexperienced investors should not trade them. Since they will not be able to handle the volatility.

    Low liquidity

    They also have less liquidity, which makes it difficult for investors to trade them without moving the market. This is also one of the reasons that explain the higher volatility. The low liquidity in turn makes penny stocks less desirable for investors with a lot of capital to deploy.

    As it becomes difficult to buy a penny stock without pushing its price up to and to sell it without pushing the price down. Penny stocks are known for being illiquid.

    Low trading volume

    Due to the lower market caps, and the nature of penny stocks, namely the low liquidity and high volatility, they also tend to have lower volumes. This reflects the fact that large investors are not interested in trading these types of stocks.

    It also is one of the reasons why the volatility is higher and contributes to a wider bid-ask spread.

    Wide bid-ask spreads

    Given the lower trading volumes, and lack of liquidity this creates a wider gap between the price buyers are willing to pay (bid) and the price sellers are willing to take (ask). Overall the bid-ask spread also contributes to the volatility in penny stocks.

    Less information available

    One of the key risks of investing in penny stocks is the lack of information available to investors. It is easy to find the financial statements of a company like Coca-Cola, however, smaller companies are not as widely covered by financial media. This leaves investors with a lot of unanswered questions and makes fundamental analysis very complicated to conduct.

    Easily manipulated

    All of this makes it easy to manipulate the price of these stocks. Since they have low trading volumes, it becomes easy to create big movements in the stock price that will pull investors in.

    The lack of information also helps to disseminate untrustworthy information about the companies, and manipulate the stock price in a certain direction.

    Prone to scams

    This makes penny stocks very prone to scams. They are usually targeted by fraudsters that try to create a movement in the stock price. These scams may include promoting such stocks or advertising them. 

    Some of the scams are even more complex, but due to the lack of oversight, and readily available information on these companies, it is easy to conduct this kind of scam.

    No analysis of the company

    The fact that penny stocks are illiquid, and there is not much information on the companies means that there aren’t many analysts covering the stock. Therefore, few investors actually try to value these businesses.

    Difficult to value 

    The lack of information, along with the uncertainty surrounding these companies, makes it difficult to value penny stocks. This pushes most fundamentally-driven investors to avoid penny stocks altogether.

    Unproven business models

    Most penny stocks are companies with unproven business models, that are difficult to predict how well they will do in the future. On top of the high volatility, it is nearly impossible to estimate the returns of penny stocks.

    No analysts covering the stock

    Due to all of these reasons most analysts do not cover any penny stocks. Therefore there are no estimates for the company in terms of its financials. This makes it even more obscure, and difficult for the average retail investor to trust in these businesses.

    Higher fees

    Additionally, penny stocks are expensive to trade. The fees to trade penny stocks are a lot higher than stocks on major exchanges, in part due to the lack of liquidity. This makes it even more expensive to trade penny stocks.

    Lack of financial statements

    While companies on large exchanges like the NYSE or NASDAQ are forced to file their financial statements regularly and are audited frequently, the same does not happen with penny stocks. This represents the lack of financial scrutiny of these companies is incomparable. Especially pink sheets penny stocks that are not forced to file financial statements with the Securities and Exchange Commission (SEC).

    Are penny stocks good or bad?

    It depends. If you are an experienced, and aggressive investor you might be able to invest in penny stocks safely. However, for inexperienced investors, penny stocks are a bad idea. This is because you will not have the know-how to research and value these companies accurately. 

    Is it hard to sell penny stocks?

    Yes, due to the low trading volume, and liquidity, as well as the wide bid-ask spread, penny stocks are difficult to sell. Since they are not as frequently traded like stocks in major exchanges it can be very difficult for investors to sell their penny stocks, especially if they own a considerable number of shares.

    Conclusion

    Penny stocks carry a considerably higher degree of risk than stocks traded on major exchanges. They should be avoided by most investors, especially those that are inexperienced. Therefore, if you are not a seasoned investor it is better to stay away from penny stocks.

    There are far better investments out there, that will guarantee you won’t lose your capital. Make sure you research every investment opportunity.

    Image source: Unsplash

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