What are the risks of investing in penny stocks?
- Limited liquidity — One of the reasons the price is so low for penny stocks is because of a lack of interest by buyers. That creates liquidity problems. When you want to sell, there may be no one to buy. That sometimes makes getting out in a hurry nearly impossible.
- Limited information — If a penny stock trades on the OTC, company information will be extremely limited, if it’s available at all. Unlike other stocks, there’s no steady flow of reports to base your investment decisions on.
- No exchange-imposed standards — Unless a penny stock is listed on the NYSE or Nasdaq; there’s no oversight. The company doesn’t have to meet any minimum exchange-imposed standards. This dramatically increases the possibility of fraudulent activity.
- Wide bid/ask spreads — Because of the low liquidity of penny stocks, the bid/ask spread can be uncomfortably large. You may pay $2.50 for a stock that usually sells for $2.00. This gives you an immediate 20% loss on your investment. This gets back to the lack of available buyers. The smaller the pool of buyers, the wider the spread will be.
- The potential for bad news — Due to the low interest in penny stocks, it would take only a few sellers — or one dumping a few thousand shares — to send the price of the stock plummeting. Just because the stock is trading at 90¢ doesn’t mean it can’t go down to 30¢. And just as the price can go up in a hurry, it can also come down just as fast. That leaves you no time to react and little opportunity to recover after the fact.
- The company could go out of business — Penny stocks represent companies that are dangling on the edge of solvency. If the company you’re invested in decides to close its doors, your investment — small that it may be — will disappear forever. Some distressed companies never recover, and most small companies never become big companies.
- Possible schemes — Keep a lookout for fraudulent deals. Watch out for pump-and-dump schemes, which is when someone claims they have insider information to inflate the price. Sometimes a promoter short sells a penny stock for a high price then gives negative news to lower the price. Also, be wary of any promoter who advises you to buy stock every time the price falls and assures you of massive profits once the price goes up.