Penny stocks are a risky investment, but despite the downsides, they're appealing to many investors. Not only are they cheap, but because the share price is so low, even small increases in dollar terms can potentially result in big percentage gains.
Yet with the advent of fractional shares, the barrier to entry in the stock market is almost nonexistent now, and the risks associated with penny stocks may make them more suitable to experienced investors.
But if you still want to learn the ins and outs of how to invest in penny stocks as well as the pros and cons, here's what you need to know.
What are penny stocks?
Penny stocks are company stocks that usually trade at a share price of less than $5, which makes them affordable for even beginner investors. They're typically offered by small companies and many don't trade on major exchanges like the New York Stock Exchange (NYSE) or NASDAQ.
Instead, if you're wondering how to get started investing in penny stocks, they’re most likely trading through the OTC Bulletin Board (OTCBB) or OTC Markets Group (sometimes called “pink sheets”).
Penny stocks are also known as “over-the-counter (OTC) stocks”, “nano-cap stocks”, and “micro-cap stocks”. Typically, the market capitalization — the total value of all outstanding shares — of OTC, nano-cap, and micro-cap stocks is less than $300 million. Nano-cap and OTC stocks generally have a market capitalization of less than $50 million, while micro-cap stocks typically have a market capitalization of less than $300 million.
You can choose to trade penny stocks through an online broker, but if you're wondering how to buy penny stocks without a broker, you may be able to contact the company directly to do so.
There are a few reasons companies list their stocks on OTC markets instead of major stock exchanges.
For starters, OTC markets don't require reporting to the Securities and Exchange Commission (SEC). This is appealing to some foreign companies that want to be listed on a U.S. exchange but don't want to file financial reports — Nestle and Nissan Motor Company are two well-known companies that do this.
Some small companies in the U.S. may also like the lack of financial reporting standards because it's more convenient — some may even have something to hide.
Also, some companies list their stocks for day trading on OTC markets because they've been delisted from a major exchange. This can happen if the company's share price has fallen below $1 for too long or it hasn't paid the required fees.
Investing in penny stocks can be risky for a number of reasons. The lack of regulations exposes investors to limited information, bankruptcy, and even fraudulent behavior.
The pros of investing in penny stocks
- Potential for big wins: It can be possible to get big gains on penny stocks, sometimes within a matter of days. That can especially be the case for small companies that have legitimate products or services, a strong financial track record, and a growing market share. (A word of caution: While big gains are possible, you may also lose money when you invest in stocks.)
- Inexpensive: Due to the growing popularity of fractional shares, which we'll cover in a minute, this benefit isn't as significant as it once was. But if you want to purchase whole shares of a company, stocks trading under $5 allow you to buy a lot more than many popular stocks on major exchanges.
The cons of investing in penny stocks
- Lack of regulation: Because the pink sheets and the OTCBB don't require SEC reporting, penny stock investors don't have much information to determine the financial health of the company they're investing in. This limited access to information could cause you to trade in a company that's close to bankruptcy without knowing it. It also makes it difficult to know whether the price of a share is warranted.
- Liquidity issues: Penny stocks trade much less frequently than stocks listed on major exchanges. This means that if you want to sell your position, you may not be able to find a buyer unless the price goes down enough to make it worth their while. If this happens, you have to take the loss.
- Market volatility: While penny stocks can offer a higher potential for large returns, that goes hand in hand with higher risk. Because there's a lack of information, share prices aren't directly tied to the company's finances, which could lead to stock prices being driven more by investor speculation. And even a small decrease in the share price could spell big losses.
- Scam potential: Price manipulation is common among penny stocks, and you could be exposed to scams.
How to protect yourself when you invest in penny stocks
If you're planning on investing in penny stocks, it's important to understand what you're getting yourself into and take steps to protect your portfolio:
- Watch out for scams: Pump-and-dump schemes are common, in which scammers hype up a stock, buy a large number of shares to boost the share price in the short-term, then sell them all at a higher price once other investors race to get in on the upswing. This often results in large losses for penny stock traders once the market recognizes that the share price is overvalued. If you suddenly hear a lot of positive information about a company, do some additional research to determine whether it's true.
- Diversify your portfolio: If you're concerned about the risk penny stocks pose, take steps to diversify your investments. For example, you may also choose to invest in index funds and stocks that trade on major exchanges, which may pose less of a risk.
- Avoid day trading: Unless you're an experienced day trader with a tried-and-true strategy, day trading penny stocks can more easily lead to losses than gains. This is primarily because it's easy for investors — especially beginners — to allow emotions to drive their trading decisions. For example, fear may cause you to sell when a share price is low, and excitement can lead you to buy when it's too high.
- Do your research: The pink sheets can include many low-quality penny stock companies, but with no access to their financial records, it can be difficult to ascertain that fact. Before you invest in a penny stock, take your time to investigate the company. For example, how long has it been around? What product or service does it sell? Can you find good things about it in the news and industry publications?
Alternatives to investing in penny stocks
If you're a beginner investor or you don't have a lot of money to put in the market, penny stocks can be appealing, but they're not the only option available.
Fractional shares allow you to invest in stocks based on how much you want to invest. For example, if a stock price of a company is $100, but you only have $50, you can purchase half a share of stock.
While you don't own a full share of the company, you can still participate in the gains, albeit at a lower dollar amount. For example, if the stock price increases by 10%, your gain would be $5 instead of $10. As with any other investment, you can also lose money by investing in fractional shares, depending on how the market performs.
There are several brokers that offer fractional share trading, including:
Minimum investments are typically $1 or $5, depending on the brokerage you choose. Many of these brokers, including Stash,2 allow you to diversify your portfolio by also purchasing fractional shares of exchange-traded funds (ETFs).1
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ETFs are like mutual funds in that they invest in a large number of securities. For example, you can buy an ETF that tracks the S&P 500, or you can purchase one that has a mix of stocks and bonds. Depending on the broker, there are typically several options available.
The main difference is that you can buy ETFs on stock exchanges, which isn't an option with mutual funds.
You may also choose to invest with a robo-advisor like Betterment. The best robo-advisors typically don't have a minimum balance requirement. Once you open an account, you'll answer a series of questions, which Betterment uses to determine how to construct your portfolio with a mix of stocks and bonds.
Then it uses algorithms to invest on your behalf. This can be a great way to invest in the market without needing to do all the research yourself as Betterment builds your investment portfolio for you. However, Betterment doesn't allow you to invest in individual stocks.
As you research all of your options with penny stocks and their alternatives, here are some other common questions you may have during the process.
Is it possible to make money with penny stocks?
Absolutely. Like any investment, it is possible to make money when you invest in penny stocks. However, there's also a high risk that you'll lose money, and that risk might be higher than if you were to invest in traditional stocks and other securities. Always do your due diligence before you invest, choose your stock picks wisely, and remember that past performance is not necessarily a predictor of future success.
How do you start investing with $100?
If you're just starting out and have $100 (or less) to invest, you have a few different options. While penny stocks are one of them, it may be better to begin with fractional shares or by using a robo-advisor. Take your time to consider all of your options based on what you want to do with your investments and how much tolerance you have for risk.
What are some alternatives to penny stocks?
If you want to invest directly in stocks, fractional shares are the best alternative to buying penny stocks. You can buy shares with as little as $1 with some brokers, giving you fractional ownership in the company. Brokers can also provide resources to help you learn how to invest money in a more effective way.
If you'd rather have someone else manage your money, consider a robo-advisor, which will create a diversified portfolio using computer algorithms based on your risk tolerance.
The bottom line
Investing in penny stocks can sound exciting, but there are many risks associated with companies that may be brand new and don't have to report their financial statements. If you're planning to invest in penny stocks, take steps to protect yourself from bad apples and scams.
If you like the idea of investing small amounts but don't want to deal with the downsides that come with penny stocks, consider using fractional shares or robo-advisors to accomplish your investment goals instead.