5 Reasons to Stay Away From Penny Stocks

Penny stocks are inexpensive equities trading for as little as pennies per share. Because they do not meet rigorous financial reporting requirements, you won't find these stocks listed on the NYSE or NASDAQ. Instead, they're traded on the over-the-counter market rather than the stock exchanges where more reputable stocks are found. You've probably heard stories about people getting rich from penny stocks, but consider these reasons to stay away. (See also: Are You Making the Biggest Investment Risk of All?)

1. You Don't Know What You Are Buying

When I look at buying something that is really cheap, my first question is, "Why is that so inexpensive?" Most penny stock is in companies with few or no assets. It's also hard to know what you are getting, since the financial reporting requirements are less rigorous than for other stocks. Without audited financial reports, it is easy to be misled as an investor and buy stock in a company that is basically worthless.

2. Penny Stocks Can Be Difficult to Sell

A big consideration for any investment is your exit strategy — how will you get your cash out? Since penny stocks are not traded on stock exchanges, it can be difficult to find a buyer when you want to sell. There are just not that many investors looking for stock in companies with low asset value and less than standard financial documentation.

3. Penny Stock Scams and Fraud

Penny stocks are often associated with scams and "pump and dump" schemes. Some penny stock investors will buy lots of shares of worthless stock, promote it through mass email as the next "hot stock," and then sell it when the stock price peaks. The stock price then goes back down and everyone who thought they were buying a hot stock is left with a loss and a stock that is hard to sell.

4. Like Day Trading, But Worse

Many people who invest in penny stocks are not investing based on the value of the business, but are trying to make money from the volatility of penny stocks — buying a stock when the price is moving up, and selling it within a few days before the price goes back down. But you know that trying to time the market is always risky. Doing this with penny stocks is even riskier than with other assets, since limited financial information is available.

5. You Will Likely Lose Money

Since penny stock companies have low asset value, there is significant risk that the company could go bankrupt and leave you with worthless stock. A buy and hold strategy for penny stocks may leave you with zero value instead of growth in the stock price. Even if you don't plan to hold a penny stock for long, you are most likely to notice a penny stock while it is "hot," meaning you are buying near the peak price and will probably lose money by the time you can sell it.

Have you ever been burned playing with penny stocks?

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