Stocks are a fundamental part of an investment portfolio. But because of the large numbers of companies offering shares, selecting stocks in which to invest can be overwhelming. To make things even more confusing, there are conflicting messages about whether penny stocks are a good choice. By looking at the disadvantages and advantages of these stocks, you can decide for yourself whether penny stocks are right for you.
The U.S. Securities and Exchange Commission defines a penny stock as any stock that sells at $5 or less per share, although in practice people might call a stock priced at up to $10 a penny stock. The low cost of penny stocks lets you invest without tying up huge amounts of money, which is good for people on a budget. It also means that if the company in which you've invested goes under, you don't lose much per share. Lastly, low cost means the same money buys more shares of penny stocks than of pricier stocks.
Penny stocks are often still in the "growth" phase, and the company that provides them has room to improve; the value of the company therefore can rise. This means penny stocks usually have a greater return potential than do higher-priced stocks in more established companies. It is possible to double or even triple your money very quickly in penny stocks.
Generally, financial experts consider stocks to be long-term investments. They also stress the importance of a well allocated, diverse portfolio, or spreading your money over lots of different investments. However, a penny stock is highly subject to change and therefore is better as a short-term investment. Investing in penny stocks makes it possible to increase your liquidity, while at the same time mixing up the types of stocks you have so your portfolio is stronger.
It's easy to make money fast with penny stocks, but you can lose everything you've invested just as quickly. Even though the return potential is high, the low price of a penny stock often reflects the fact the company is in distress. Some companies offer penny stocks in a last-ditch effort to secure capital to avoid bankruptcy or pay debts.
Even when a company is not in distress, low price usually shows the company is not as well known or well established, and there is no guarantee that it will make it in the market. Low price also reflects lower demand, so you might not be able to find someone to buy your stock for as much as you paid. Penny stocks are extremely risky and not for faint-of-heart investors.
Lack of Regulation
The U.S. Securities and Exchange Commission does not regulate penny stocks the way it does other stocks. Subsequently, companies that offer penny stocks are not required to provide investors with basic financial information that would be useful in making decisions about the status of the company and the stock. This is a disadvantage, considering the amount of risk that penny stocks already have.
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Wanda Thibodeaux is a freelance writer and editor based in Eagan, Minn. She has been published in both print and Web publications and has written on everything from fly fishing to parenting. She currently works through her business website, Takingdictation.com, which functions globally and welcomes new clients.