Pros and Cons of Investing in Penny Stocks

Dec 30, 2009
William Pirraglia

Newer investors often believe that penny stocks are a perfect way to start their career. Investing in penny stock, but, can be a minefield. Veteran investors are aware of the potential results and traverse the universe of penny stocks carefully.

What Are Penny Stocks?

The definition of a penny stock is rather like a “moving target.” Penny stocks mean different things to different people and markets. Depending on the stock market involved, penny stock is more a generic term than a specific class of investment.

For example, in the U.S., a penny stock is often classified as one that sells for less than $5.00 and is typically traded over-the-counter (usually directly by broker-dealers), outside of the large stock exchanges. Conversely, in the U.K., penny stocks usually refer to small-cap investments. Small-cap stocks are those that are offered by smaller companies. There is no universal agreement on this definition either. It varies with the stock market and even individual brokerage firms.

Yet, penny stocks, while seldom costing one cent, are lower priced, often risky investments, and relatively unknown in the market. There are reasons to invest in them and expert wisdom that cautions avoiding in penny stock.

Pros and Cons of Investing in Penny Stocks

First, the pros:

• Low per share cost. May translate to less potential money loss. This doesn’t affect the “risk” of loss, but may reduce the amount of money risk.
• Ability to buy a larger “position” in a company. The investor can theoretically buy more shares to therefore hold a larger percentage of a company. Winning penny stocks might deliver brilliant profit because the investor can buy more shares.
• May find some hidden treasures. Ignored by the major markets, penny stock can sometimes return high profit margins to excellent or lucky investors. Penny stock that proves to be strong will typically generate higher percentage returns than most blue chip stocks.

Now, the cons:

• High risk. While there are some unidentified winners in the penny stock universe, smart investors are aware of the inherent risk. Smaller companies are often under-financed, carry significant debt, and may lack a positive competitive edge in their market.
• Finding a winner may still result in low profit. Some experts consider this the major potential problem with penny stocks. Having shares that increase in value by a large percentage (30% to 50%) will generate smaller real profits, unless you have many shares.
• Solid reasons why stocks may be ignored. While a penny stock with fabulous potential may be ignored simply because the company is small, other reasons (e.g., lack of strong cash flow, capital to market products effectively, or inability to generate more financing) are often real warning signs of future problems.

To Buy or Not to Buy, That Is the Question

All investments are a combination of business and personal preference decisions. This rule-of-thumb is never more right than a choice to buy penny stocks. Much depends on the size of a person’s investment account dollars, their comfort level with risk, and their confidence in reading stock charts and spotting trends.

Investing in the stock market has the potential for larger returns and losses than most other investment options. Penny stock is the “poster child” for this reality. Fortunes have been made and lost by these companies and their investors. As long as a portfolio is diversified, penny stocks may be a profitable component, but small the percentage they may be of one’s investment account.