The Risks and Rewards of Investing in Penny Stocks

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The low price tag of penny stocks lures in new investors seeking their first stocks to buy; however, that low price tag does not accurately reflect the risk involved with investing in penny stocks. These stocks under 5 or stocks under 1 may just as easily indicate growth potential as they could expose a company going broke. With a little background knowledge on how to size up the options, you can increase your chances of having excellent luck investing in penny stocks.

Most penny stocks are traded on either FINRA’s OTC Bulletin Board (OTCBB) or on Pink Sheets.

While it is advisable to be cautious on both of these exchanges, it is especially true of Pink Sheets. The nearly 15K stocks trading on Pink Sheets are not required to (or cannot) file with every investor’s ally, the Securities and Exchange Commission (SEC). Companies on this exchange are either de-listed from the bigger exchanges, unable to meet the requirements of the major Nasdaq or NYSE exchanges, have stocks dropping below $1.00, or are a foreign company unable or unwilling to meet major exchange requirements.

Buying stocks on the OTCBB requires investor awareness as well; the set up for the OTCBB makes it hard for investors to gather adequate information to discern between viable or corrupt penny stocks options. Similar to Pink Sheets, there are no set, minimum standards for a company to reside on the OTCBB; this creates an environment primed for scam artists.

Penny stocks are perfect bait for scammers who know how attractive lower costs are to brand new investors. Here are five typical scams potentially lurking behind cheap penny stocks:

#1 – Scammers encouraging you to invest in penny stocks may have a mining scam in place. Remember David Walsh – the founder of Bre-X? He was involved in a famous mining scam in which he lied about his company having found a large gold mine in Burma. This story pushed all the company’s penny stocks value, increasing the company’s worth to nearly $6 billion. When the truth came out, investors lost big.

#2 – The less obvious reverse merger scam can appear legitimate and result in big losses after buying penny stocks. Private company mergers with public companies occur in the business world in order for private companies to promote publicly traded stocks without taking a more laborious, traditional route of getting listed. These quiet mergers make lying about company earnings to increase stock prices rather easy. When in doubt about a merger, always research the business history of the relevant companies.

#3 – Smart investors researching penny stocks should be well informed about the infamous “pump-and-dump” scams. Arguably, this kind of penny stocks fraud is the most common. Scammers will advertise new, hot penny stocks poised to rise and make magical dollars which “pumps” up the price of the stock when multiple investors buy into the claims. Scammers wait for the stock to rise to a certain amount before they “dump” or sell the stock, leaving investors with nothing while the scammers get away with a large profit. Most of these scams are run through paid ads in free penny stocks newsletters.

#4 – Another common scam attached to buying penny stocks is known as the “guru scam.” In this set up, investors come across an ad or an e-mail from an “insider” who claims to have the key to unlocking obscene wealth through buying hot penny stocks. If someone acts like a magic genie with all the answers, run and don’t look back.

#5 – A scammer using penny stocks to attract unsuspecting investors may use what could be considered the reverse of “pump-and-dump” scam known as “Short-and-Distort.” “Shorting” is a term for borrowing shares and then immediately selling for a high price with the hope that the company stock will drop so the seller can collect the sold shares for less money. A scammer will target penny stocks to ensure a stock drop by circulating rumors about the relevant company.

Is buying penny stocks really worth the risk of getting scammed? 

The obvious reward to buying penny stocks is creating a diversified portfolio with a small initial investment. There are a few important steps to follow if you have the tolerance to endure the risk of avoiding the common penny stocks scams.

Firstly, verify liquidity and trading volumes before buying penny stocks. Even if you find you’re successful at identifying promising penny stocks for your investment, you need to be able to sell at some point. To avoid finding yourself without many buyers and stuck with wide bid-ask spreads preventing you from making a profit, secure reasonable liquidity and trading volume in your penny stocks.

Secondly, diversify and limit your holdings in penny stocks. It’s recommended to cap losses in penny stocks to 1-2% of your overall portfolio. As you diversify, you may want to avoid exceeding 5-10% of your overall portfolio.

Thirdly, search for high quality penny stocks and know when to sell. Look for experienced managers who have exited a previous company professionally and stocks with binomial outcomes (like promising resource companies). No matter how high quality you believe the stock to be, the penny stocks sector is constructed on short-term trades and are rarely the sort of long-term investments worth holding.

How does one avoid scams when investing in penny stocks?

If you take the time to learn how to avoid scams in penny stocks, your ROI on that time is doubled; the same information will guide you when investing in higher priced Nasdaq or NYSE stocks. Don’t fall for an over-hyped, persuasive ad which was intentionally written to gain your confidence rather than to tell the truth about a company’s penny stocks.

Always perform your own research and verify with your own good sense whether or not you’re investing in a quality company with open disclosure of operations, achievable business plans, no substantial debt history, and credible business management. If a proven company in which you wish to invest has a strong track record, you many find their penny stocks will reward you with a decent profit.

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