Few investors want to be the conservative bondholder, who sits and watch his government-protected Treasuries earn him 2% interest. Most dream of being the one who invests in the cheap, unknown growth stocks which will gain 1000% or more over time. For many, penny stocks are the gateway to making this dream a reality. But penny stocks can carry many risks and dangers for those who invest unaware. Are they the right investment for you?
What are Penny Stocks?
In the United States, penny stocks are stocks of small companies that don’t have a high share value. Their name come from the fact that most penny stocks are only worth pennies to buy, although many people consider stocks that cost less than five dollars and have a small market capitalization to be penny stocks. These stocks are usually not allowed to trade on the major stock exchanges like the NASDAQ and the NYSE, so they have to trade on the Over-The-Counter Bulletin Board (OTCBB) or the Pink Sheets depending on whether they report quarterly earnings or not.
What to look for in Penny Stocks
Investing in penny stocks is not as much a matter of what to look for, but what to avoid. One of the main attractions with penny stocks is their price. Many new investors buy stocks with the same though process they buy retail items: If the item is cheap, it must be a good deal! Unfortunately, stock picking isn’t that easy. The most common metric for evaluating stocks is P/E, or price to earnings. A low P/E means a stock is probably cheap, depending on the average P/E for stocks in its sector.
Since many penny stocks don’t have a strong earnings history, the best way to decide whether a penny stock company is good or not is to look at management or the idea behind the company. If the management has had previous success running companies, or is an expert in a certain field, their company has a better chance of being a real company. Also, some investors specialize in buying up companies who have one specific idea with the hopes of a major company buying the small company out. This plan works best in the technology and biotech sectors.
The Danger of Penny Stocks
There are a vast amount of dangers associated with penny stocks, which explains why the rewards can be so much larger than for blue-chip stocks. The biggest danger involves the risk of bankruptcy. Most of the companies whose stocks aren’t listed on either the NYSE or the NASDAQ don’t have a strong history to justify investment. They may not have consistent earnings or any earnings at all. Strong companies with good earnings go bankrupt all the time; the risk increases for stocks without earnings. Additionally, made stocks that stay on the pink sheets are fraudulent. There is no oversight or regulation over stocks there, so some stocks are issued with no company to back it up. Also, many penny stocks don’t ever make money for their owners. They get big, stay as a penny stock, or go bankrupt.
For most investors, the risk of penny stocks is too high for the rewards. A combination of bonds and blue-chip stocks suits many people’s risk profile quite well. But for the people who need the extra risk in their lives, penny stocks suits the role. Investor just need to make sure they understand the risks before choosing penny stocks.