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13 reasons why penny stocks are risky: What to know before investing

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Penny investments

There is often a fine line between investing and gambling, and penny stocks are where many investors cross that line. That does not mean that all penny stocks are a bad risk, but they are a big risk.

Here are 13 important things to know about penny stocks before investing in them:

1. These days, penny stocks can cost a few dollars per share

As with "penny candy," inflation has made the term "penny stock" something of a misnomer. Anything trading below $5 a share might be referred to as a penny stock, and they are sometimes called by the more accurate name "microcap stocks." This means their capitalization, or total value of the company, is very low relative to most traded companies.

2. The real significance of penny stocks is looser listing requirements

Penny stocks don't meet the listing requirements of the NYSE or NASDAQ, so you should be advised that the requirements for how they compile and disclose information are less stringent.

3. Your broker should ask you to sign off on a detailed, written warning before trading penny stocks

This is a requirement of the U.S. Securities and Exchange Commission, and if your broker does not get your signature on this before you trade in penny stocks for the first time, you should be suspicious.

4. Penny stocks can be an incubator for growing companies - or the graveyard of dying ones

Penny stocks excite people because they are viewed as investments in up-and-coming companies. That may be true, though private equity investment is likely to get the most promising companies through the start-up phase before they trade publicly. Penny stocks can also be a venue for stocks on their way down, including companies that have been de-listed from the major exchanges.

5. Over-the-counter trading is likely to be more expensive than exchange trading

Ask what compensation your broker is earning on a trade. It may sound like just pennies a share, but in penny stocks that can represent a large percentage of your purchase price. Figure out that percentage, and then double that because you may pay a similar level of broker compensation on the way out of the stock. That combined total is the amount the stock will have to increase just to break even on trading costs.

6. Large spreads can be very costly

Over-the-counter stocks trade with what are known as bid-asked spreads. This is the gap between what buyers are offering for the stock and what sellers are asking for it. The wider the gap relative to the price of the stock, the bigger the concession you are likely to have to make to buy it. If no bid is listed, it means no one has even offered to buy the stock lately, and that is a real warning sign.

7. Losing everything is a distinct possibility

Even small changes in penny stock prices can represent a large percentage gain or loss, and these are often companies on shaky enough ground that you should be prepared to lose your entire investment.

8. Liquidity can be a problem

These are obscure stocks that may not trade very frequently. Once you get in, you might not be able to get out when you want to.

9. Beware the letter Q

A stock symbol ending in the letter Q means the company has filed for bankruptcy.

10. Information can be hard to come by

Some penny stocks meet SEC filing requirements, but some do not. Especially for those that do not, timely and legitimate information can be hard to track down.

11. Focus on the info you can verify

Don't rely on information from people promoting the stock. SEC filings (if available), news stories about the underlying business and even your own experience with a company are better sources.

12. Penny stocks can be especially prone to scams

For several of the above reasons - low price, laxer regulation, thin liquidity and scant information - penny stocks are a favorite of scam operators. These scams can range from owners of a stock hyping it for a quick gain to people promoting a dormant or shell company as having active business operations.

13. Get-rich-quick stories are compelling - and rare

The "I made $250,000 in two weeks" stories are popular penny stock come-ons, but even if true, these are a small minority of the trading experiences in these stocks. Don't be influenced by hype.

The best way to find a good penny stock is to do your own research and find one that represents a promising investment in a fundamentally sound business. In contrast, if someone approaches you with the idea of buying a penny stock as a get-rich-quick opportunity, your warning bells should be sounding.

Tell us: Do you invest in penny stocks? What investing advice do you have to give for new investors?

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