Don’t Put More Than 1% of Your Net Worth in Penny Stocks

Every now and then a friend of mine asks me what I think about penny stocks.  The official definition of a “penny stock” given by the SEC is any stock that trades below $5, but of course what this person typically has in mind are the real bottom of the barrel equities that trade for literally pennies.

And I can see the longing (or is that desperation?) in their eyes.  Inevitably this is someone relatively young who has been grinding in the real world just long enough to (1) sock away some money, and (2) realize that working full-time isn’t all that appetizing and that if they could only invest $1,000 in a stock worth $0.01 today, and if that stock goes to $10, they would be a millionaire and could quit their job and never worry about money ever again.

And here’s the advice that I give them, and it’s the advice I give you: “Don’t put more than 1% of your net worth in penny stocks.”  (Don’t know your net worth?  That’s OK.  Read this.)

So if your net worth is $10,000, then don’t invest more than $100 in penny stocks.  If your net worth is $1,000, don’t invest more than $10 in penny stocks.  If your net worth is negative, you have no business whatsoever investing in penny stocks, and I recommend that you read this and this.

This way, you can get your adrenaline rush, and when you (likely) lose almost all your money you’ll thank me that you only lost 1% of your net worth rather than 10% or (God forbid) 100%.  Believe me — it’s happened.

So why am I such a Debbie Downer on penny stocks?  There are many reasons, but I’ll give you my top ones.  Hopefully they’re convincing enough for you to not bet the farm on pennies.

Penny Stocks are Cheap for a Reason

And it’s usually a bad one.  Oftentimes, penny stocks are either on the verge of bankruptcy, with their liabilities exceeding their assets.  Think about what this means for a second.  It means that these companies typically owe more than they have.

Would you buy a house for $100,000 if the mortgage on it was $150,000?  No?  Then why would you buy a share of a company that has $1,000,000 of assets and $1,500,000 of debt?

If these penny stocks were such great investments, why are they only trading for pennies?  If they really were on the verge of turning around and becoming profitable again, don’t you think at least somebody else would be buying them?

Penny Stocks are Not Well-Regulated

Most stocks you hear about on the news are traded on national stock exchanges like the New York Stock Exchange, NASDAQ, or the American Stock Exchange.  And the companies whose stocks trade on these exchanges are highly regulated and must disclose certain key information to their investors.

Not so with penny stocks, at least not the “bottom of the barrel” penny stocks that my friends usually bring up.  These stocks typically do not trade on national stock exchanges, which means that it will likely be very difficult for you to get the information you need to decide whether or not such a stock would make a good investment.

Penny Stocks are Easily Manipulated

You would need a lot of money to manipulate the price of Coca-Cola or Microsoft stock.  Tens and hundreds of millions of dollars of those companies’ shares trade every single day.  In order for one investor to significantly impact the stock price, they would have to invest a lot.

Penny stocks, however, are traded much less frequently.  This makes it possible for someone with only $100,000 or even $10,000 to manipulate a penny stock for their gain and your loss.  Also, because penny stocks trade so infrequently, you may not even be able to sell your penny stocks once you own them!

A Word About Penny Stock Newsletters and Gurus

You may have received an email from a penny stock guru telling you to sign up for his newsletter or website.  If you choose to sign up, proceed with extreme caution.  Because penny stocks are so easily manipulated (see above), it is all too common that a penny stock guru buys thousands of shares of these penny stocks and then the next day advises his readers to all buy that penny stock.  This sudden influx of buyers will likely raise the price of the penny stock (because their daily volume is so low)…and then the guru sells, deflating the price.  He’s made a handsome profit, while all his readers are left holding the bag.  And the crappiest part is that many of his readers will still follow him because he will tell them, “Look!  The price went up!  I sold while I could.  You just got greedy and didn’t get out in time!”

So go ahead.  Put a few bucks into penny stocks.   But before you do, I suggest you read How to Invest in the Stock Market.  🙂