There is a considerable number of small public companies in the United States that trade around a dollar per share. These are called penny stocks. Some investors are attracted to these stocks because of their low share prices. Others have also considered some of these stocks as speculative stocks due to their long-term growth potential which makes them ideal for speculative investing. However, while it is true that their share price makes them more accessible to the public, and that their potential can also be considered some form of growth investing, investing in penny stocks carries higher risks than established small-cap, mid-cap, and large-cap stocks. This article lists and explains the pros and cons of penny stocks.
Investing in Penny Stocks: What are the Advantages and Disadvantages?
The Securities and Exchange Commission does not have a strict definition of what penny stock is. An older criterion was that any small company that trades its common share for less than USD 1.00 is considered a penny stock but the SEC has used the term to refer to small public companies that trade less than USD 5.00 per share. It is also important to note that the stock price of a particular company can fluctuate above and below the generally-accepted threshold but it might not always be considered a penny stock. Nevertheless, when it comes to the prospects of investing in penny stocks, it is important to understand their advantages and disadvantages.
Pros of Penny Stocks
The availability of penny stocks lowers the entry barrier to stock investing. The low cost of entry of these stocks makes them ideal for investors who want to invest in stocks for the first time or want to expand their stock portfolios. Below are the specific advantages of penny stocks:
• Affordable Stock Investing: Remember that penny stocks trade for less than USD 5.00 per share. This price allows investors to get started in stock investing and also enables them to purchase a large number of shares for a smaller amount of capital. There is also a decent selection of companies to choose from for a diversified portfolio.
• High Returns Opportunity: These stocks have the potential for high growth. This can happen through future business expansion or if they become a target for acquisition. Investing in them can fall within the realms of speculative investing and growth investing. Some penny stocks can be considered speculative stocks or growth stocks.
• Early Investment Benefits: It is also worth mentioning that there are small and emerging companies or startups with stock prices that trade within the range of penny stocks. This suggests a potential for faster growth once their business or products take off. The rapid growth is often reflected in a substantial increase in their stock prices.
Cons of Penny Stocks
Investing in penny stocks can be a hit or miss. Small public companies have an appeal because of their potential to become bigger in the future. However, in several instances, there are companies that either close down or have stagnated. Below are the disadvantages of penny stocks:
• High Risk and High Volatility: One of the main disadvantages of investing in penny stocks is that it exposes investors to heightened risks of stock investing. These risks come from their unproven track record and limited liquidity. Their size also makes them vulnerable to external factors. Their prices can also be very volatile.
• Limited Market Information: It is also important to underscore the fact that available information about penny stocks is either limited or unreliable. This makes it hard for investors to conduct in-depth research or perform fundamental analysis to assess their true potential for growth and make informed investment decisions.
• Susceptible to Scam and Fraud: Penny stocks are not subject to the same level of scrutiny as more established stocks. This makes them an avenue for fraud or scams like a pump-and-dump scheme that involves fraudulent companies artificially inflating the stock price through misleading information before selling their shares for profits.
• Alternative Investment Options: The low costs of penny stocks make them appealing but it is still important to note that these are not the only options. There are pooled funds like mutual funds and unit investment trusts that start below USD 50.00. Fractional shares also present an opportunity for investing in more established stocks.
Important Pointers: How to Evaluate the Pros and Cons of Penny Stocks?
The growth potential of a particular penny stock is enticing. However, like in other investment opportunities, this growth is not universal across all companies offering these stocks. An important consideration in evaluating the pros and cons of penny stocks is the availability of relevant information. The general rule is not to invest in companies with scarce or inexistent information or in those with information but cannot be validated through cross-referencing. The breadth of information should include audited financial statements and other financial data, sales performance and market share, public sentiments like user reviews, and the current and projected future performance of the industries or markets where specific prospected companies operate.