you’ve heard about an elderly widow being swindled out of her life’s savings by some con artist over the phone, or some 14-year-old child running a pump-and-dump scheme out of his mother’s basement, such awful stories have some basis in reality. By recognizing this fact, you will be able to sidestep potential pitfalls much more easily.
Penny stocks represent low-quality companies
Stocks rise in value when the underlying company does well and fall in value when the business does poorly. Therefore, more successful companies typically have higher share prices, while the majority of troubled businesses become penny stocks, if they aren’t trading at those levels already.
When a penny stock company does really well, its shares tend to move higher and eventually may rise above five dollars per share. And as soon as the price rises above five dollars, the stock is no longer considered a penny stock. As a consequence, the universe of penny stocks is made up of only the companies that have not yet done well enough to rise above penny stock territory. The result is that penny stocks are lower-quality companies, and lower-quality companies tend to be penny stocks.
If you want to play in the universe of penny stocks, you will need to have at least two characteristics:
• A good filter. The better you are at screening out the lower-caliber companies, and the more effective you are at finding the up-and-coming corporations, the more impressive your results will be.
• A strong stomach. You need to be able to handle the higher volatility and potential downside if you’re going to be involved with penny stocks.
You may not have a good filter at first. You may not have a strong stomach when you start out. However, you can gain these attributes over time in direct proportion to how involved you become with trading speculative, low-priced shares.
Penny stocks are subject to price manipulation scams
Because penny stocks are more thinly traded, and prices are much lower per share, they tend to be easy targets for price manipulation. They also tend to represent lower-quality companies and trade on markets with fewer manipulation controls and regulatory oversight.
Pump-and-dump artists may drive up the shares of near bankrupt companies through their free online newsletter, only to take their profits and walk away. When they stop promoting the shares, the stock crashes back down. Dishonest promoters may paint a very weak company in a positive light, a process called putting lipstick on a pig.
In any case, the prices of shares may rise well above what they are realistically worth. This price manipulation puts investors (who haven’t done proper due diligence) at significant risk, because shares always return to their appropriate valuations. The good news is that you can avoid these types of price manipulation pitfalls pretty easily by following the guidance I offer in Chapter 4.
Trading penny stocks is a game of chance
For some investors, penny stock investing can be like a playing a slot machine at the casino or buying a lottery ticket. Such investors have resigned themselves to the fact that they are taking a chance on a big gain, but will probably lose. The house odds are stacked against them.
But traders who perform proper due diligence never consider penny stock investing like gambling. They only invest their money when the “odds” are stacked in their favor. They have a clear understanding of which penny stocks to avoid, and which are likely to increase in price, and why, and when.
Whether or not penny stock trading is like playing at the casino depends on how you approach your trades.
The number-one reason people get involved in penny stocks is to get rich quick. They have a few hundred dollars, which they need to turn into several million before the weekend so they can buy a yacht and pay their telephone bill.
The likelihood of getting rich quickly from penny stocks is slim (although it is possible). My experience has shown me that those who want to get rich quickly never do. Those who focus on investing well, and perform their own due diligence, tend to do dramatically better.
Penny stocks appeal to the impatient
I am an impatient investor. Perhaps that’s why I was drawn to penny stocks myself. In fact, a significant proportion of investors who follow me, as well as those who seek out low-priced shares through other channels, tend to embrace the volatility of the underlying investments. The potential to make significant moves very rapidly appeals to them, even as it exposes them to equivalent downside risks.
While impatience may be the reason why many investors seek out penny stocks, this character trait can cause investment problems. Impatient investors may sell shares at inopportune times, such as just before the stock begins reflecting stronger operational results. They may jump from investment to investment in a constant hunt for profits, which can lead to many poor trading choices (not to mention excessive brokerage commission fees).
To succeed with penny stocks, you need to choose contemplation over impatience. Give the underlying company time to let its business plan play out. As long as the penny stock is making progress, however slow, and the reasons you got involved with it in the first place still hold true, let the shares gradually reflect the improving operational results.
The greatest gains in penny stocks come over years, not days. Shares that balloon from 5¢ to $5 only do so over the course of longer time frames, and one winner of this magnitude will trump all the 5 percent and 20 percent profits you may see from decades of trading. But only patient investors have the wherewithal to enjoy these kinds of opportunity.
Newer investors gravitate to penny stocks
Typically, newer investors are interested in penny stocks because they believe there is less downside. They find smaller and newer companies less intimidating, and they expect such investments to be more attainable and appropriate for their minimal level of trading experience.
Although such reasoning isn’t without merit, it can be dangerous. There is just as much downside risk in a 1¢ stock as in a $99 stock (100 percent loss potential in each case). Also, finding high-quality penny stocks is much more difficult than uncovering good investments among larger shares, mainly because low-priced stocks have fewer companies of high caliber and a greater percentage of lackluster options.
Despite the aforementioned pitfalls, newer investors may find many benefits to starting off with low-priced shares:
❯❯ Broader diversity of investments. Newer investors will learn much more from trading numerous types of investments, rather than just buying one or two. With penny stocks, you can spread a small investment among several stocks.
❯❯ Greater volatility. Larger and ostensibly more boring investments will not teach their shareholders much. Penny stocks will display greater volatility
