At some point, many new investors experience a temporary love affair with penny stocks. The allure of buying one hundred thousand shares of a stock for a few thousand dollars can make a new investor feel like a big fish. After all, if a stock that is trading for a dime moves to only two or three dollars, a fortune could be made. This is true; however, a stock that moves from 10 cents to $2 has to go up the same percentage as a $10 stock does to reach $200. Furthermore, the 10 cent stock has some other hurdles to jump through, as well. Granted, there are stocks that began as low priced stocks that have gone on to make tremendous gains but this is the exception, not the rule.
A penny stock, by SEC definition, is a stock that is trading for under $5 per share. Thanks to the recent bear market, there have been some blue chip companies that are now trading in this single digit area and these stocks may not fit the true blueprint of a typical penny stock.
One of the hurdles a penny stock faces is the lack of institutional support. This means that these stocks are not on institutions' radar screens as buy candidates. This is important because institutional sponsorship is what typically moves a stock price higher.
A misconception is that after a stock has made a tremendous move and undergone numerous stock splits, it will be quoted as selling for pennies on a split adjusted basis 10 year before. This is not completely accurate as the stock may not have ever been available to the public at this price, but only appears this way when looked at in the rearview mirror.
Another challenge for a penny stock investor is to find any meaningful information about the company. Penny stocks or microcap stocks as they are referred to in the financial world are listed on theOTCBB exchange or in the Pink Sheets. The requirements to be listed on the OTCBB are not as strict as the NASDAQ or NYSE and companies do not have to make as much information public if they are listed in the Pink Sheets. To put it in Monopoly terms, The Pink Sheets are like Baltic Ave. and the NYSE is like Park Place. This is important for several reasons, one of which is less regulatory oversight. The possibility for fraud is increased in the Pink Sheets due to less reporting requirements.
While there are many reputable companies that may be listed in the Pink Sheets or OTCBB, there is increased risk and less common success to be found in this arena for the majority of investors. Given that there are so many stocks to choose from on bigger exchanges, if investing is your goal, then higher quality stocks are a smart choice. If you have an appetite for lower quality stocks, I am not suggesting you avoid them altogether, just don’t consider the money you put into these stocks an investment, instead consider it a gamble.