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What Are Penny Stocks & How Do They Work?

February 25, 2019 · 4 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What Are Penny Stocks & How Do They Work?

There is a certain allure to the story: A distant uncle who swears he knows about this great investment that’ll cost you next to nothing. An old roommate that analyzes stock charts all day and identified some new, skyrocketing tech company. A cab driver who tells you he struck it rich by playing penny stocks.

Honestly, who isn’t enticed at the thought of a cheap investment that could make you rich? Still, you take these stories with a grain of salt, because you’re rightly skeptical of claims for “getting rich quick.”

Often, when people talk about such an investment, they’re referring to penny stocks.

Penny stocks, which are technically any stock trading for less than $5 per share but often less than $1, often find themselves at the center of a debate on whether people should even consider investing in them. While penny stocks can turn a profit, it is also possible to lose big in penny stocks.

Today, we’ll be answering the questions “What are penny stocks?” and “How do penny stocks work?” Additionally, we will explore the pros and cons of penny stock investing along with a discussion of who should invest in penny stocks and whether there are better options available for investors.

Exploring Penny Stocks & How They Work

First, let’s review the definition of a stock. A stock is a piece of ownership in company, called a share, and is traded on an exchange like the New York Stock Exchange or the NASDAQ. You can own a stock in “public companies,” which simply means that they can be owned by people like you and me.

Penny stocks generally represent small companies, some of whom are new, or don’t even have positive earnings. They are usually much smaller companies than you would see on one of the big dog exchanges.

Companies that file to have their stock traded on the major exchanges are subject to a high degree of scrutiny but because penny stocks don’t file on an exchange, they are not subject to such inspection. They are also generally not subject to the same regulatory scrutiny as companies that are listed on major exchanges.

Companies that issue penny stocks often lack resources. When they create stock shares for investors to purchase, it is on a smaller scale. That, combined with low demand for most penny stocks, creates an illiquid market. This can make it difficult for investors to sell their penny stocks on demand.

How do penny stocks work? To buy a penny stock, buyers must do so in the over-the-counter (OTC) markets such as the OTC Bulletin Board. These markets are also sometimes called “pink slips,” after the color of the physical papers that investors acquire when a penny stock transaction is completed. Rarely, a higher-priced penny stock will trade on the NASDAQ or one of the foreign exchanges.

Penny Stocks Are Highly Speculative

Here’s an important thing to understand about all investments: Risk and reward are two sides of the same coin. You cannot have one without the other. If it is possible to make a run-away amount of money, then it must be coupled with a similar amount of risk. Beware of anyone who claims otherwise.

Being both high-risk and having a potential for high reward are the defining characteristics of penny stocks. Therefore, any investor who wants to try their hand at penny stocks must have an appetite for risk.

Pros of Penny Stocks

High Reward Potential

It is possible to get a high return on a penny stock. Not only is this the nature of high-risk investments, but the multiplier (price compared to company earnings) on small stocks has the potential to grow rapidly. There is a belief that small stocks have more room to grow than large stocks.

Enjoyment

Just as some people like to gamble, others like to invest for fun. Plenty of people would consider analyzing stock charts, reading up on new, interesting companies, and making bets one of their hobbies. Investors like this might want to consider penny stocks as “fun spending,” not investing.

Cons of Penny Stocks

Small Likelihood of Success

Making a lot of money on a penny stock is an extremely rare occurrence. Investors should be aware of this, despite the tales of sudden wealth they may hear. Also, contrary to popular belief, success by investing in penny stocks can often take a long time.

Possibility of Losing it All

A small likelihood for success means that there will inevitably be many failures. It is quite common for small, unestablished businesses to fold and go under, or flounder, or simply have unsuccessful stock. When stocks become worthless, investors lose all of their money.

Volatility: Penny stocks are highly volatile, which means that their prices can change a lot, rapidly. This can happen in either direction, which makes them a difficult tool for building long-term wealth.

Scammers: The penny stock business is ripe with scammers. There are thousands of penny stock newsletters promising big wins and penny stock “investors” manipulating both the market and potential customers.

If DIY investing to achieve long-term growth seems overwhelming, there are now some great, affordable options for investors. Companies like SoFi manage wealth portfolios that consider your goals, risk, and timeline, and help you invest accordingly.

Best of all, we utilize low-cost index funds to build a tailored strategy. Unlike the “old way” of investing, there are no crazy hidden fees that eat away at your wealth.
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The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member
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