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How to Invest in Penny Stocks and Scams to Avoid

Investing in penny stocks isn’t a get-rich-quick scheme but can be a part of your overall investment strategy

We haven’t talked about penny stocks yet on the blog and for good reason. Stocks of the smallest companies are hugely risky and you can lose your entire investment quickly. The easy answer to whether you should even invest in penny stocks is usually no but it’s kind of a cop out.

You can’t write off any investment without looking at your own needs and how it fits with the larger portfolio picture.

We’ll first look at what defines penny stocks from other investments before we get into why you should invest in penny stocks and why you might want to avoid them.

What are Penny Stocks

Penny stocks don’t necessarily trade for pennies per share. Instead the stocks are often called ‘micro-cap stocks’ because they are companies worth less than $300 million and with very low trading volume. That size a company may seem very large but it’s miniscule compared to small cap stocks which are companies of $1.5 billion and the mega-cap companies like Apple that reach into the hundreds of billions.

These very small companies may not file all the same financial reports as larger companies so it can be more difficult to get all the facts on management and finances.

Penny stock companies generally trade in the over-the-counter market, an electronic stock market that doesn’t have some of the stricter requirements for listing on the New York Stock Exchange or Nasdaq. You can still buy them from just about any online investing platform and there isn’t much difference compared to other stocks other than the lower trading volume.

That lower trading volume or liquidity can be one of the problems of penny stocks. Since shares trade for around a dollar or less, you’re probably going to be buying many more than you would a stock trading at a higher price. There are not nearly as many investors constantly buying and selling penny stocks so it may be harder to buy or sell the stock you want. This generally means you have to pay a premium on the market price.

Why you Should Invest in Penny Stocks

Penny stocks are notoriously risky with prices that can jump double-digits overnight only to fall back without warning. A funny thing happens though when you put a bunch of penny stocks together…they don’t look nearly as risky anymore.

Take a look at the chart below showing the iShares Micro-Cap ETF (IWC), a fund of more than 1,400 micro-cap stocks, against the S&P 500 market index.

risks of penny stocks investing

The penny stocks fund has nearly mirrored the stock market over the last ten years before under-performing this year as investors worry about the end of the bull market. While it proves a point that diversifying your investments across many stocks, the micro-cap fund probably isn’t the best way to invest.

There are so many stocks within the fund, it pretty much balances out and you might as well invest in a general market fund with lower expenses.

The real benefit to investing in penny stocks comes with a little sweat equity, digging into the financial reports and industry research. Basically, penny stock investing is the market equivalent of venture capital funds and angel investing groups. These professional investing groups look for very early-stage companies with shaky financials but profitable futures.

There is a lot more work investing in penny stocks compared to other stocks. You’ll have to dig deeper into financial statements and learn a little about forensics accounting, becoming a financial Sherlock Holmes.

What’s in it for the investor willing to put in the extra work? Penny stocks have the potential to boost your investment returns significantly, even on a fairly small investment. You could have bought Monster Beverage Corporation (MNST) for just $0.07 per share on an adjusted basis in 1995. The surge in popularity of energy drinks and natural foods took the company along for a ride and the stock now trades for $150 per share, a gain of 214,000% or 46% a year.

It would have taken an investment of just $466 in 1995 to cash out a millionaire in 2015.

Of course, many more penny stocks go bust or inch along with the market. The trick is learning the deep financial analysis that can find the winners.

How NOT to Invest in Penny Stocks

Investing in penny stocks doesn’t have to be super-risky or a get-rich-quick scheme doomed to fail. You don’t need to pay some internet guru hundreds of dollars for the ‘system’ they used to make millions. Penny stocks can be another part of your diversified investment strategy just like investing in different asset classes or different sectors within stocks.

invest in penny stock scamsUnfortunately, the financial media has perverted penny stock investing just as it’s done with investing in general. That 200,000% return on shares of Monster Beverage got your attention, right? TV entertainers and online scammers have used the excitement of potential of micro-cap stocks to turn the idea into a get-rich-quick promise.

Despite what you see on TV, investing in penny stocks isn’t about huge short-term gains. Jumping in and out of a stock in anything less than a year is just going to lose your money and line your broker’s pocket with fees. Investing in penny stocks is about finding great micro-cap companies with the potential to be household brands sometime in the future.

Understand that TV programs and investing websites need to keep things exciting to keep you coming back for more. That means constantly pitching ‘great investment ideas’ in penny stocks. Follow all these recommendations and you’ll end up owning the entire stock market.

  • It’s ok to get an idea for an investment from a TV or internet analyst but you need to be much more selective before you actually hit the buy button. You might end up investing in just one for every 20 stock ideas you hear but you’re much more likely to avoid the losers if you spend a little time doing your own research.
  • Don’t invest just because a stock price has soared. There might be a reason the shares have done well but the fact that the price is higher doesn’t mean it’s a good stock.
  • Plan on giving your penny stock investments at least three to five years to really make money. That’s the amount of time venture capital and angel investor groups invest in early-stage companies before cashing out.

Check out our 10 Investing Basics to learn the secret agenda of the investing media and why you can’t invest on TV or internet recommendations.

Penny Stock Scams to Avoid

People hear the penny stock success stories and they get dollar signs in their eyes. It leaves them vulnerable to all kinds of penny stock scams and scoundrels. Scam artists will pass themselves off as stock market analysts or investors with a fool-proof system for finding the best stocks.

They’ll either try getting you to buy the shares or pay for their advice, either way you’ll end up losing your money. If you feel you’ve encountered a penny stock scam, contact the SEC or your state’s securities regulator immediately.

  • Be cautious of any email or phone message you receive telling you about a hot penny stock tip. The most recent scam is where the fraudster pretends to misdial or sends the email tip to the wrong address. Don’t be fooled, it was just a spam email trying to make the sender look like a legitimate investor.
  • Penny stock websites will show a series of trades that have made the investor rich, sometimes even showing documents of trades made and returns. What they don’t show you is that the scammer actually started ten or more separate portfolios and then picked the one with the best returns. They might have lost money if you look at all the investments together but just cherry-picking one portfolio makes it look like they’re a stock-picking genius.
  • The ‘pump and dump’ scheme is a common penny stock scam. The scammers buy a bunch of shares and then use the internet and phone to pump up the price before selling out quickly. They’ll post in investing forums, websites and anywhere they can to claim inside information that the stock is going to surge. Many will even set up ‘boiler rooms’ where a whole room of people call out and pressure people to buy. The share price does go up for a little while as the fraudsters keep pitching the stock but then comes crashing down after they’ve sold out and stop promoting it.

If you do decide to invest in penny stocks, remember a few key points:

  • Stick to one industry in which you have formal experience, what Peter Lynch refers to as ‘invest in what you know.’ This will help you understand the risks and opportunities for companies in the industry.
  • Take the time to learn financial accounting and some of the financial shenanigans that get played with penny stock companies.
  • Make penny stocks a small part of your total investment portfolio, maybe 10% or less. This reduces your risk but can still boost your overall return by finding a few gems.
  • Create a penny stocks fund on Motif Investing to reduce your trading costs. Motif allows you to group up to 30 stocks and buy them all at once, for one $10 fee. You don’t need 1,400 penny stocks like the iShares fund but selecting 20 or 30 of your favorites will help ensure at least one high-flyer.

You don’t have to completely avoid micro-cap stocks in fear of penny stock scams. While individual companies are riskier, investing in penny stocks can actually help to reduce your overall risk through diversification. Understand the basic rules when you invest in penny stocks and avoid the hype…and you’ll avoid the penny stock traps and losing your money.

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