Buying Penny Stocks: A Solid Investment?

Penny stocks are the most volatile of investments, reserved only for those with a wide risk tolerance and the financial ability to take risks. With that said, penny stocks also offer huge potential returns as a result of their low share prices. Though the name would suggest that the stock must trade for less than one dollar, penny stocks are actually stocks that have a per share price of less than $5.

Why Penny Stocks are Risky

Though not always the case, many penny stocks represent smaller firms that simply do not have the staying power of the big names on Wall Street. Small businesses generally have a harder time staying afloat in times of economic uncertainty; when business softens, the smaller names are usually the first to go. Larger companies have both the a strong name in business and the credit to borrow money, even when business is slowing. Also, penny stocks are highly leveraged, in that a small drop in revenue can easily make a small corporation fail. Penny stocks are very much speculative and should not be a large part of an important portfolio; penny stocks for retirement portfolios are off limits for most investors as the turbulent market conditions make them far riskier.

Penny Stocks are Thinly Traded

Most penny stock listings receive very little attention, and thus trade fewer than a few hundred thousand shares per day. Due to low volume, large percentage movements in penny stock prices should be expected, as a $.05 movement on a $1 stock represents a 5% gain. Movements like these are the norm for penny stocks; a large volume order can easily push a penny stock up or down as much as 10% just to get the buyers or sellers it needs to complete a trade.  When you buy or sell stock, you will be buying from one or many different people, and with the low volume of penny stocks, to complete the transaction of a large volume of stock, several sellers might have to be bought out at different price points. This translates into a large movement in stock price relative to the overall cost.

The Different Penny Stock Exchanges

Penny stocks are listed on many different exchanges. There are the larger exchanges, including the New York Stock Exchange and the NASDAQ, but also the Pink Sheets and over the counter (OTC) exchanges where penny stocks are more popular. The Pink Sheets and OTC stocks are considerably more risky because they disclose much less information than the other markets. Stocks listed on the Pink Sheets disclose very little information to traders as a result of lesser SEC regulations.

What Role Should Penny Stocks Play in a Portfolio?

Most investors go through their entire investment careers without ever dedicating both time and investment dollars to penny stocks. There is a great deal of risk and careful planning that should go into making penny stocks a part of a portfolio. Disposable income, rather than retirement savings, should be used to trade penny stocks. There is simply too much risk to make penny stocks an asset that backs a future retirement plan.