What are penny stocks? Are penny stocks risky?

Penny stocks, also known as cent stocks, are shares of small public companies that trade at very low prices.

The US Securities and Exchange Commission (SEC) defines a penny stock as being a share valued below $5 and not listed on a national exchange. In the UK, penny stocks usually cost less than £1 each.

Since the 2008 global financial crisis, when several blue-chip companies’ stock prices fell below $5, the definition of penny stocks has changed slightly. Today they tend to be defined as stocks which are extremely cheap, illiquid, or they are listed on a small exchange.

These stocks pose a high level of risk for investors, who are often tempted to buy them in the hope of generating large and quick profits.

Penny stocks are much riskier than blue chip stocks

Penny stocks are very volatile and are considered to be one of the highest risk investments due to a serious lack of liquidity, huge bid-ask spreads, small capitalization and limited following and disclosure.

For the most part, people invest in penny stocks in the hope of receiving large and quick profits.

In the USA, penny stocks are often traded over-the-counter on the OTC Bulletin Board, or Pink Sheets. Over-the-counter stocks are those belonging to companies that are not listed in the stock exchanges.

According to Cambridge Dictionaries Online, a penny stock is:

“A share with a very low value because it is considered a high-risk investment, for example in a company that is small, little known, or not very successful.”

Why are penny stocks risky?

The companies that issue penny stocks are not required to disclose as much information with the SEC as a larger corporation does, and are much less regulated than stocks represented on the NYSE or NASDAQ.

They do not have to fulfill minimum standard requirements to remain on the exchange.

Pump and dump

Penny stocks are frequently targets of stock promoters and manipulators. These stock manipulators buy large quantities of a particular stock and artificially inflate the share price through misleading (or even false) positive statements. This is a form of microcap stock fraud.

For example, a group of individuals could buy millions of shares in a penny stock company and then promote the stock by sending newsletter and writing in websites, talking about it in chat rooms or stock message boards, publishing fake press releases, or doing e-mail blasts.

What to know before investing in penny stocks

It is a common misconception that big blue chip companies, such as Microsoft, were once penny stocks that have appreciated in value because of their ‘adjusted stock price’. This often makes people feel more confident with their investment decision. (Blue-chip companies are large, well-established firms, whose stocks are considered to be a safe investment.)

However, it shouldn’t as these companies usually start at a rather high price that continues to increase until they need to be split.

People are often lured into investing in penny stocks; they believe that there is a much higher chance for appreciation, given that a $1,000 investment can buy 10,000 shares.

Now, while there is a chance that these stocks can double in value, they can also lose half (if not all their value) just as easily. Most penny stocks end up performing poorly.