Penny Stocks: Risk and (improbable) Reward

News of “penny stocks” has probably invaded the sides of your browser at some point with news of some (supposed) penny stock millionaire. But what, exactly, are these penny stocks, and is it a worthwhile investing venue?

Generally speaking, the SEC classifies penny stocks as stocks that trade under $5 and aren’t listed on major exchanges like NASDAQ or the NYSE. Instead, they’ll be traded on pink sheets or over the counter bulletin boards. One can purchase shares of penny stocks through your normal stockbroker.

The appeal of penny stocks comes in the form of their volatility. Much in the same way prospectors of the old west would pan for specks of gold in the river, investors will pore through penny stocks in the hope of picking out the next big breakthrough company whose shares will jump from .10 to $8. And also like those prospectors, most of them won’t.

Penny stocks suffer from several problems. Typically, little information is available to the investor, and there is rarely performance history to look at. They also don’t have to meet the same standards that companies must meet to be traded on the major exchanges. Selling the stock may also be a problem, since not many buyers may be willing to take the risk.

Aside from general instability and extreme volatility, penny stocks are particularly vulnerable to “pump and dump” schemes set up by scammers. In these setups, people will purchase a more or less worthless stock, hype it to investors who purchase it, in turn raising the stock price, and then selling the stock and leaving the investors high and dry.

So while penny stocks may have made a few folks rich, it’s not likely to be your best investing opportunity. But that diamond-in-the-rough potential is exactly why they’re popular amongst the least risk-averse among us.