First Federal Bank Blog

If you’re interested in investing, you’ve probably heard penny stocks mentioned somewhere along the line. With lower purchase prices and the potential for huge growth, you may be tempted to jump right in and spread your money around. But before you make your moves, it’s wise to understand what these stocks are, how they work, and the potential risks they carry.
 
What is a penny stock?
 
As the name probably suggests, penny stocks are stocks you can purchase for a low price. John Divine, a senior financial markets editor for U.S. News & World Report, writes that any stock that trades for less than $5 a share falls into this category.
 
These stocks typically belong to small companies with little or no market value, and as such, most penny stocks tend to trade via over-the-counter transactions, otherwise known as pink sheets. However, Divine notes it is possible to find penny stocks traded on the Nasdaq or New York Stock Exchange.
 
What essentially makes these stocks attractive is the idea of getting in on the ground floor with a company that has some growth potential. And with an intelligent strategy and some luck, these stocks can pay off in the long run. As Investopedia contributor Chris B. Murphy points out, Amazon was at one point in its history traded as a penny stock. But in many cases, the risks of investing in penny stocks tend to outstrip the reward.
 
Potential risks of investing in penny stocks
 
Murphy notes penny stocks can be incredibly volatile. While this may contribute to substantial returns on investment, it also makes them exponentially riskier than proven stocks. As such, it’s not typically advisable that you make them a significant part of your portfolio, especially since they are often attached to unproven companies.
 
What’s more, trading through less-conventional means also means most penny stocks are not beholden to the same disclosure roles as stocks moved on a larger exchange. Stocks listed via over-the-counter pink sheets don’t have to report to the Securities Exchange Commission, which means you may not have the information necessary to ensure you’re making a sound investment in a stable company. Before you invest in a penny stock, you should do as much research as possible to try and get a sense of the company and its trajectory.
 
Another significant problem surrounding penny stocks due to the lack of regulation is the potential for scams and fraud. Keith Noonan, a contributor with The Motley Fool, says penny stocks are often the subject of what’s known as a, "pump-and-dump" scheme. In these instances, scammers will artificially inflate hype around a penny stock, leading investors to buy and increase share prices in the process. Once there’s profit enough to be made, the scammers cash out and the shares decline, saddling investors with losses.
 
It's entirely possible to purchase penny stocks in a legitimate company and make money once it takes off. But your best bet would be to consider this avenue only if you have room for higher-risk assets in your portfolio and don’t invest more money than you’re comfortably willing to lose. If you’re interested in penny stocks, a good move may be to work with a trusted and reputable broker familiar with penny stocks.