With some big name companies trading at over $1,000 per share nowadays, investors with less cash to pour into their portfolios are often intrigued by the potential of penny stocks, which are also referred to as over-the-counter or OTC stocks. As the name implies, these stocks are super cheap, typically trading at less than $1.00 per share (though the SEC defines penny stocks as those trading below $5.00 per share).
Since they’re not traded on major stock exchanges, investors can find more information about penny stocks through the OTC Bulletin Board or OTC Markets Group. Penny stocks are typically offered by small, newer companies that have less information publicly accessible to potential investors, which can either pose a great risk or reward depending on the investor’s research, portfolio management practices and…well, luck.
On the surface, investing in penny stocks seems reasonable: you can accumulate many shares without breaking the bank and a share price increase of just a dime or quarter’s worth could effectively double or triple your initial investment’s value, depending on how much you originally paid per share.
However, when we dig deeper into penny stocks, some serious problems arise. They’re volatile, high-risk, highly speculative and generally don’t add much value to your portfolio. To unpack this, let’s examine the 5 main reasons why penny stocks just aren’t worth your time and money.
Limited Access to Penny Stock Investments
Many traditional and online brokerages don’t offer penny stocks to their investors and even those that do offer a very limited selection to choose from. The rationale behind this is due to the inherent volatility of penny stocks (more on this later), which makes this type of investment simply too risky for many brokerages to allow their investors to get involved in.
If you really want to try your hand at penny stock investing, then you can find penny stocks through E*TRADE, Schwab Brokerage, Interactive Brokers or Trade Station, to name a few. Proceed with caution, however. Many of these brokerages charge as much as $5-7 per trade, which can make penny stock investing as a waste of money if you’re not purchasing a higher volume of shares to justify the cost of commissions.
Targets of Investment Fraud
Another common problem with penny stocks is that investment scammers gravitate towards penny stocks for “pump and dump” schemes. These involve hyping up a little-known company and pouring money into its stocks to artificially pump up its price-per-share before quickly dumping shares while they can still turn a profit.
Meanwhile, investors who jumped in when the stock price was already on the rise get left with stocks worth less than the initial price paid per share (if they’re worth anything at all after the scammers finish the “dumping” process).
Thanks to their low prices and attractiveness to investment scammers, penny stocks are among the most volatile investments out there. Dropping a few cents in value may not sound like much.
But, if you invest $2,000 in penny stocks worth $0.20 per share (so 10,000 shares) and the price per share plummets to $0.12 per share, then your $2,000 investment is now worth $1,200 – and there’s little probability they will return to $0.20 per share or more any time soon, if historical penny stock performances are anything to go by.
As if the potential for scams and jaw-dropping volatility weren’t enough, penny stocks carry the additional disadvantage of tax complications. Very few investors hold on to penny stocks for more than a year, which means your gains are taxed at your regular income tax rate instead of the long-term capital gains tax rate (which is lower than income tax rates in most cases).
Additionally, the volume of penny stock shares in your portfolio can cause accounting problems if you don’t carefully track how much you owe well in advance of tax filing deadlines. This presents a double-bind situation for penny stock investors: either they invest in a high volume of penny stocks (which makes tax time much more of a headache) or they invest in only a few shares of penny stocks, which is incredibly inefficient when you consider the time it takes to research companies and trading fees/commissions you’ll pay for each transaction.
What Should I Invest in Instead of Penny Stocks?
Penny stocks may seem attractive for investors without much cash up front to put into investments, but there are far better ways for you to invest without wasting your time and money on OTC trading. For one, you could add more dividend stocks to your portfolio and set up a dividend reinvestment plan (DRIP). This option will allow you to reap the rewards of (relatively) stable and well-established companies while automating your gains with reinvested dividends.
Another option would be to purchase fractional shares of stocks you otherwise wouldn’t be able to afford if one full share was the minimum purchase requirement. You can buy fractional shares through an online investment platform like Stockpile, which charges just $0.99 per trade and gives you access to numerous quality stock and ETF options.
M1 Finance gives the more established, sophisticated investors great investing options. M1 Finance simplifies the investment process for beginning and experienced investors alike. Unlike other robo-advisors, M1 Finance does not charge a fee, and it gives you the option of taking more control over your investments if you want them (and less if you don’t).
Why spend countless hours researching potentially lucrative penny stocks when you have comparatively stable opportunities to get higher returns on your investments without so much risk? Unless you really want to get involved in penny stocks and thoroughly understand the risks beforehand, avoid this type of investment at all costs.