The Risks of Buying Penny Stocks

If you’ve ever been tempted by the supposed “high gains” in penny stocks, you’re not alone.  Penny stocks are like the siren song of the investing world.  They seem like a lucrative path upfront but there are many dangers and risks when you buy penny stocks that often go unnoticed when a novice investor begins their new career or investment strategy.  In reality most (if not all) people should avoid penny stocks because the time and knowledge required to overcome the risks almost always greater than the average person is willing or able to put in.

After choosing from the various online penny stock brokers available, the first skill a penny stock trader would have to master is highly disciplined money management.  You can’t simply invest in penny stocks with whatever amount of money you feel at the moment like you can in your 401k with safe balanced mutual funds.  The volatility and bankruptcy levels of individual penny stocks is huge.  If you put all of your money into one stock there is a huge chance you will lose it all.  You really can’t afford to risk more than 2% of your money on any investment or trade.  Are you willing to follow 50 different penny stocks?  Or are you willing to study definitions of risk and statistical models so you can determine the risk on any given trade?

The next factor the penny stock trader would have to learn that is beyond the average trader is mass psychology.  In penny stocks marketing is often employed to manipulate stock prices over the short term.  The large companies and financial instruments are protected by Wall Street money which will keep the true value of a stock because they’ll sell when it’s over priced and buy when it’s under priced.  These large money institutions can’t trade in the pink sheets so there is less free market protection.

The last extra task for an aspiring penny stock investor is information gathering.  Stock brokers and websites do a great job covering all the large companies with all the information anyone could possible require.  With penny stocks there is no agency that is publicly regulating the information for the company.  False press releases and phony websites are common place in the penny stock world.  Digging up real information and filtering good information from bad is a new skill to most investors, but is essential before you even think about penny stock investing.

For vast majority of investors (myself included) the high risks of penny stocks simply do not outweigh the potential extra gains.  If you are looking for a high risk career with little chance of long term success then penny stocks may be for you but for the rest of us, “boring” solid investments win the race.