If it costs less, it’s a bargain, right? But not all bargains are worth the money. Some time ago, I wrote about why I thought that buying penny stocks is a big mistake. Now I’m joined by fellow PF blogger Tim Parker from Elementary Finance who gives his own thoughts on the subject.
One particular Saturday not long ago, I was doing my weekly grocery shopping. The local store that I go to has a bargain bin. You should see some of the items that are in there: some of the products in the bin are products that I’ve never heard of nor would I buy them, no matter how cheap. I don’t think I’m alone either. The same products can be found on this rack every week.
Inevitably, though, we both know that somebody will come around and see value in these items. I’ve fallen into this trap myself. More often than not, I’m wrong. These items are cheap because they hold little value. We’ve all figured this out at least once.
You wouldn’t think that something as sophisticated at the stock market would have a bargain bin, would you? The stock market attracts many of the brightest minds in the business world. Surely, every stock is valuable!
But not only does the market have a bargain bin, you will be surprised to hear that it’s huge. It’s as easy to spot as it is at the supermarket, where people are attracted to it en masse. This particular discount bin carries penny stocks.
No Penny Stock Trading For Me, Here’s Why
I don’t have any direct evidence on this, so take this view as my own theory. The reason that the stock market can be dangerous (or perceived dangerous) for the average investor is because we’re not really dealing with tangible assets here. To look at our supermarket analogy again, if you went to the bread isle and there was a loaf of bread for one dollar and a moldy loaf of bread for 50 cents, which would you buy? Surely, you would pay a little extra money to buy the good loaf!
Everyday, though, amateur investors go shopping for the moldy loaf. They find stocks that are literally on sale for pennies and they buy up because they see the cheap price tag. But here are two reasons why penny stocks just don’t make sense.
1. You’ll need to make high volume trades to make money.
First, in order to make any money, you are going to have to invest a sizable amount of money regardless of the stock that you buy. A penny stock may move 1 or 2 cents on average. In order to make money off of a move like that, you are going to need 1,000 shares just to make $20. That barely covers the broker’s commission. The nature of the beast here is that penny stocks are only suitable for very short term trades. Because of their high risk and volatility, it’s not a good idea to own them for long. Penny stocks will force you to become a trader.
If you have $1,000 to spend, why not buy 20 shares of Walmart for the same price? It’s a better company and you stand to make money over time. You don’t save any money by purchasing shares in a bad company. In this case, the moldy bread will cost you the same amount of money as the good loaf. Yet I know too many people who buy the lower priced stocks because they equate the low price for good value, when in fact, they should be valuing a stock based on parameters like its P/E ratio….which leads me to my next point.
2. Penny stocks are hard to value.
You don’t know a penny stock’s true value. High quality companies trade millions and over tens of millions of shares of stock per day. Well followed, high quality stocks are easier to value. Penny stocks often trade very few shares (they’re thinly traded), which means that there are a wide variety of offers circulating. Often the sellers and buyers are far apart (large bid-offer spread). Because of this, it’s hard to find out the true value of such a stock.
So take away this lesson: We know how to find true value in our everyday life. We can tell the difference between the good stuff vs the bad when we walk into most stores. We should use the same rules when buying stocks. If it’s a penny stock, that means nobody wants it. If nobody wants it, it’s not valuable. If it’s not valuable, you need to stay away. Just my .02.
Copyright © 2009 The Digerati Life. All Rights Reserved.
{ 22 comments… read them below or add one }
I never buy penny stocks too. I’ve rarely seen a company that does well but its stock still trades for less than a buck. It is theoretically possible for a good company to have a penny stock, but I don’t remember seeing that in practice.
They are penny stocks for a reason after all. Good article I never buy penny stocks either, and I have 1 more thing to add.
Pump and Dump schemes are all over the “penny stock market” a lot of people making money there are doing it by illegally scamming the common investor, not something I want to get into, especially when you can make money by investing good solid stocks.
Having to use large amounts of money (leverage) to make a decent return is a red flag to me. Maybe it’s not easy to define, but it seems to go against rules of prudent investing and money management. Perhaps lack of diversification?
Why would anyone want to buy penny stocks, except for Pump and Dump schemes? I guess some people might actually think they’ve found a company that is on the rebound.
Paul
i am also sceptical about these penny stocks. i did a post about them some time back and i plan on retweaking and reposting it because i have a feeling that my readers have forgotten about them. when i do this i will link to this post because i like the logic in the post
I would never dream of buying a penny stock.
I don’t think it follows that there is no one alive who could do it successfully.
It strikes me as the sort of thing where you would have to devote years of effort to the project before putting money at stake to have any hope of success.
Rob
That is similar to the “penny” or “nickel” slot machines, they can still be 5$ a spin with max credits, and without playing the max it’s nothing much if you do win.
I have a confession to make: I was actually a victim of a “pump and dump” scheme on a penny stock a couple of years ago. I am ashamed to even admit it! I was scouring some stock forums (Yahoo! Finance I believe) and for whatever reason, a particular stock enamored me — or at least, I was enamored by the discussion in the threads about it. People were slamming the stock while some others were singing its praises. I was intrigued by the mixed discussion as well as the track record of the stock. Needless to say, I fell for it. I know now it was a complete set up. There were people in the forum threads pretending to be skeptical while others were saying they had insider knowledge on the stock and that we were all fools for being skeptical.
I dropped $3,000 on this stupid thing and emerged from the experience $1,250 or so lighter. That was one of the most stupid moves I’ve ever done. This plus my foray into L.A. Gear at its heydey. Weird that no matter how long I’ve had experience in the investment arena, I still feel that I am vulnerable to mistakes and foolish moves like this. Experience helps to counteract human psychology, but sometimes, we can still be slaves to that psychology (base emotions of greed and fear).
I made money on only one penny stock. All others where losers. It’s high-stakes gambling plain and simple. I agree with you – people should avoid all penny stocks like a swine flu.
I agree. I was taught to only deal with long-term stock opportunities. Less risk, same, if not better reward.
I was a victim of pump and dump once as well. But when investing in penny stocks after a while you start to see those cheap promoters. If it’s a forum usually they have low post count and come in groups which is kind of funny. Unfortunately some do fall for it before experienced members can get to the post.
Penny stocks are really volatile so it is important to know the details of what the company does. I’ve also done the same mistake before, so I think we’ll just have to learn our lessons from these.
Never say “Never!”
At the start of 2009, at least in the UK (I don’t know enough about USA stocks), there were many bargains to be had – quality companies at bargain prices, due to credit crunch. These were large caps that the market had revalued downward (massively) and at that time had become penny stocks. Many of these stocks have since increased in value, even though they are below previous peak prices. For long term investors, they were a sensible buy (if not a “steal”) at the start of the year for those of us who weren’t scared to buy – too many people were panicking and holding cash.
e.g. LSE: BARC.L (Barclays bank) £0.51 in January, now trading at £3.75. LSE: AGA.L (Aga food services – the upmarket kitchen stoves) £0.5025 in January, now trading at £1.30.
(I’ve tried to pick stocks I own that would be known outside the UK, but I apologise if not. This isn’t a recommendation to buy the above – do your own research – you’d probably need a time machine anyway!)
If the last 12 months can teach investors anything, it’s that the market does get prices wrong. Volatility has been crazy, whether you look at a stock or an index – it doesn’t match what happens in the real world. Hence there are occasions when healthy companies can be temporarily valued below their truth worth – use your skills, experience AND common sense to decide if the stock price is low for a genuine reason or if it’s a bargain.
I admit that different rules apply to penny stocks that are (potential) growth stocks i.e technology, biopharm etc. However, there is a place for investors to allocate a small percentage of their portfolio to such stocks. Either let a professional fund manager seek out such opportunities or do your own research – but it takes time and effort. Ignore the scam artists – and in that vein, I’m not going to mention any such stocks I own or am looking at 🙂
Finally, what’s so special about the number 1.00? Would you invest if a stock is priced at 1.01, but not 0.99? Taking this to a conclusion, why not buy if the stock is 0.01? (I think the lowest priced stock I’ve bought this year was about £0.05, currently trading at £0.1175 and I hope much more for the long term).
Tally ho!
Penny stock aspirants need not worry too much over how they can get started. For the procedure required to be followed in the case of penny stocks is similar to those applicable to other stocks.
My concern with penny stocks is that the Internet has turned them into a get-rich-quick scheme for luring doe-eyed newbies.
You can make money with penny stocks… but if anything, it is a more complex and risky investment endeavor than most. Because of its name — it’s just a cent, right? — it is made to look as if it has easy entry.
In fact, penny stock trading should be exercised by people with more experience and savvy… not by novices.
Truth to form article. Sometimes we waste time and money on things that are bad thinking that we can turn it around but it only frustrate one. Not saying that all pennies stock are worthless because you know this is the stock market and if the individual is willing to work hard then it will become successful. Remember that sometimes out of bad cometh good.
Nice post. I also tell my readers not to focus on buying “penny stocks”. Why buy them when you can buy low market cap stocks, with a lot of value!
Good article. Usually being traded for $5 or less than that per share over the counter (OTC) through quotation services, these penny stocks have limited liquidity and can sharply change.
hile we all dream about investing in the next Microsoft or the Home Depot, and actually mentally start calculating the profits, the sad truth is that the odds of finding out that once in a decade, success stories are slim since these companies are either start-ups or have purchased a shell company as it was cheaper than an IPO, or they just do not have a business plan that is good enough to justify investment banker’s money for an IPO. This doesn’t make them a bad investment, but it should make you be realistic about the kind of company you are investing in.
Siri is a penny stock and it started out well below a dollar and it’s at $ 1.69 now and I think it will go far higher……..I believe picking the right penny stock can happen….
Front running is a technique used in penny stocks scams. It is also known as insider trading. In this method, scammers use inside information on a stock that’s about to take off. They take large positions before the news is revealed.
@DeonLee,
Sounds like bait and switch or pump and dump!
I think perhaps we need to define a “penny stock” better. Example: Siri is a legitimate company but is a “penny stock.” I believe the exchange that the penny stock is trading on can help an investor have a little more confidence in the company and stock. If the company is a pinksheet stock…well that may be more risk than a otcbb stock, which is better, but an Amex stock is event better. See my point? AIG was a penny stock for a short while but look at it now $36 a share.