Why Are Penny Stocks Bad? (Risks and Avoidance Strategies)
Why are penny stocks bad? The internet is flooded with arguments and courses on how to get rich in penny stocks. Hence, penny stocks attract a lot of attention, both among investors and traders, but also among scammers, unfortunately. The traps in penny stocks are many, and we recommend staying away from penny stocks. These stocks are not a way to get rich. They are more likely to send you to the poorhouse.
Penny stocks are bad because many of the companies have unproven business models, they are illiquid, they are exposed to scammers, and they are very volatile. Most penny stocks end up worthless. It’s very difficult to find consistently profitable penny stock strategies.
Penny Stocks are touted as the holy grail in trading for people with less money to get rich quickly. Unfortunately, the reality is that most traders lose a lot of on them.
Penny stocks: Extremely inexpensive equities that are worth substantially less than what they cost.
– Don Staricka
What are penny stocks?
Despite their name, penny stocks do not always trade in pennies, sometimes in dollars: The American SEC uses a much wider definition: any stock below 5 USD is a penny stock. There is no exact definition, but the majority of them don’t trade on any formal stock exchange like NYSE or Nasdaq:
Where are penny stocks traded?
Penny stocks are traded on all US exchanges, but the great majority of them are on the over-the-counter (OTC) and the private Pink Sheets. The Pink Sheets is a private company that offers a listing service for stocks that trade over-the-counter. OTC stocks are simply stocks that are not listed on a formal exchange like NYSE or Nasdaq. The OTC market is being served by a network of broker-dealers to make a market. The whole purpose of the OTC market is to serve as a marketplace for small companies to bring together business ideas and investors for those companies which can’t make it to the exchanges or don’t want to.
Why do companies trade on the OTC markets and not on any exchange?
Both the New York Stock Exchange and Nasdaq are stock exchanges, and have strict requirements to get listed. Very few companies can comply with the exchanges’ requirements as it’s expensive. A rare few companies elect to stay on the OTC rather than the exchanges, but they are the exception.
Why trade penny stocks?
Most people are drawn to penny stocks because they dream of striking it rich.
This is of course unlikely to happen. Traders and investors with small accounts dream of making a killing in these stocks, but are much more likely to end up as prey for bigger and more informed players higher in the food chain. These are often scammers.
The typical arguments for trading penny stocks are these:
- You don’t need a big account to trade them. A stock at 10 000 shares at 10 cents is worth only 1 000 USD.
- They are very volatile – you can hit a home run – a multi-bagger. An increase from 10 cents to 20 cents is 100%, while only 10 cents in gain.
- The OTC market is like a lottery ticket. We know from behavioral studies that investors are attracted to binary outcomes.
- Scammers are attracted (because they know investors enjoy lotteries).
- Most companies once started small.
Any stock that has the potential of becoming a multi-bagger looks attractive, no matter how low the odds are. But all your efforts have an opportunity cost: are your resources better spent elsewhere? How likely is it that you will be successful in trading low-priced stocks? Do you have the competence to deal in unregulated markets?
John Deere (DE) is likely to become a multi-bagger, but you need to own it for decades. This is not attractive to penny stock traders. The ability to delay gratification is a rare thing to have, and stories about traders making a killing in penny stocks are simply too hard to resist. Thus, you go looking for the next diamond on the Pink Sheets instead of John Deere.
One famous trader in penny stocks wrote this on his website:
Oh – and just to put this into context, although the S&P 500 topped 30% returns in 2013, its annualized return between 1926 and 2013 is only about 10%. Since more than nine out of ten professional money managers fail to beat the S&P 500, it’s going to take even longer to turn a tiny account into a million dollar holding through traditional stock market investing….. I don’t know about you, but I don’t want to wait that long!
Yes, why invest for “only” 10% when you can get 30% and more trading penny stocks? This is the lure of the OTC markets. Don’t fool yourself! Richard Feynman wrote that the first principle is that you must not fool yourself – and you are the easiest person to fool.
The quote above is typical for many websites, but surely something you will never hear us tout at Quantified Strategies. In order to get more than the market’s 10% annual return, you either need to take a lot of risks, find a temporary inefficiency or simply be very good at developing quantitative strategies.
It’s of course possible to make a lot of money trading. We have been reasonably successful ourselves, but don’t fool yourself to think that penny stocks are the holy grail. It’s not.
Has anyone ever gotten rich trading penny stocks?
Of course, but you never hear about the ones losing their shirt (and homes). The argument is often that any large-cap once started small. But you can’t look at the success stories without looking at the stocks gone into oblivion. It’s easy to overestimate yourself using hindsight.