It’s true. It’s possible for investors to make a fortune on penny stocks.
But while it’s possible, it’s exceedingly rare, and though the allure of buying a stock at 11 cents and selling it for $20 may sound too tempting to pass up, the truth is straightforward: Stop looking for the best penny stocks to buy — it’s not worth your time.
Finding a penny stock worth buying truly is like finding a needle in a haystack.
[See: The 25 Best Blue-Chip Stocks to Buy for 2017.]
Follow the money. The fact that there is no legitimate penny stock index, for instance, is a nice way to visualize their lack of investment value. If they were actually good for investors, you’d be able to buy the Vanguard Pink Sheets Admiral Fund through your retirement account.
The point would-be penny stock speculators should understand is that, broadly speaking, penny stocks have a shoddy reputation due to their poor performance as an investment category.
This is not true of, say, the Standard & Poor’s 500 index, and it implies that to make the risk worth it, you’ll have to miraculously identify the extremely rare success story, time your buy and sell decisions correctly, and manage not to lose your profits in subsequent trades.
Unfortunately, that’s not the the biggest problem with penny stocks.
Liquidity: penny stocks don’t have it. Stocks less than $1 aren’t known for their liquidity — an investment’s ability to be easily and quickly converted into cash.
For example, the OTCQX Composite index may be the closest thing to a legitimate penny stock index out there today. But aside from minimum liquidity requirements, the company running the index, OTC Markets, has “sole discretion” to choose which companies listed on its marketplace also appear in the index, defeating the point of an all-encompassing index.
The liquidity standards require stocks in the index to post “one trade at least every 10 trading days,” a downright pitiful standard. Imagine you have to pull your money out of the market to pay a hospital bill or send your kid to school. “Could you just wait two weeks until we find a buyer? If we ever do?”
There’s another huge problem with illiquidity.
“Stocks on major stock exchanges are very liquid and have a very narrow bid-ask spread at any time. That is, the price a seller can realize is very close to the price a buyer has to pay,” says Bob Johnson, president and CEO of the American College of Financial Services in Bryn Mawr, Pennsylvania.
“With penny stocks, however, the bid-ask spread can be substantial. This makes it very difficult for investors to realize a gain in penny stocks,” Johnson says.
They’re rife with fraud. Looking for the best penny stocks to buy is almost like trying to find the blackest swan in the pond.
It turns out a species of black swan actually does exist, but it took the Western world until nearly the 18th century to discover it (in Australia), and it would not have been wise of 17th century Europeans to bet that the next swan they saw would be black, even though it was technically possible.
Not only is the universe of penny stocks notoriously illiquid but it teems with fraudulent narratives and pump-and-dump schemes that enrich a few insiders at the hands of the masses.
“The bottom line is: 99 percent of penny stocks are manipulated by heavy insider trading. Most will eventually be delisted and you easily could lose your entire investment,” says Ethan Parker, founder and CEO of Treble.
They’re cheap for a reason. It’s reductive but true: Penny stocks became cheap by either never having a great business to begin with or falling out of their customers’ good graces.
[See: 7 Stocks That Could Save Your Portfolio.]
Quality companies just don’t find their shares trading for less than a buck — it almost never happens. If you look back at a chart of Microsoft Corp. (ticker: MSFT) and see that it was going for 10 cents a share back in 1986, it’s actually deceiving. That’s the split-adjusted price of MSFT stock back in those days — in reality, its IPO price was $21 a share.
If you find yourself ready to buy a penny stock you’ve been sold on for one reason or another, first ask yourself what’s wrong — because there’s always a problem.
In recent memory, shares of companies with household names like Radio Shack and Borders suffered long, secular declines into penny stock territory — where stocks often go before they die (both did).
Opacity. Failed energy giant Enron famously had a “black box” from which it mysteriously generated enormous profits. In other words, investors had no idea exactly how a lot of its earnings came rolling in. That secretive accounting raised some suspicions that were later validated by its collapse.
Penny stocks don’t have to provide much transparency to investors, and in fact companies that trade on the pink sheets have absolutely zero financial reporting obligations. You will not find the next Amazon.com ( AMZN) or Apple ( AAPL) living in the world of pink sheets.
Opportunity cost. The real point of outlining these general traits of penny stocks is not to indict every single one of them. It’s true: if, in March 2009 at the bottom of the Great Recession, you’d been wise enough to buy Pier 1 Imports ( PIR) at its lows, you could’ve gotten in at 11 cents and ridden it to highs above $25/share roughly four years later.
But at the time, the economy was in tatters and everyone thought Pier 1 was on the verge of getting delisted. People win the lottery from time to time, but that doesn’t make lotto tickets a good investment. It’s not just money at stake, but the time you spend studying penny stocks that you could be spending on something else.
It’s a far better plan to keep it simple by routinely investing in low-cost stock market indices over long periods of time, an investing strategy that has still earned investors about 10 percent annually over time. One of the most natural human instincts is greed, but it can often end up working against itself.
If you’re dead set on beating the market, at least avoid handicapping yourself by limiting your search to penny stocks. You can easily find cheap stocks to buy for less than $10 without sacrificing liquidity, a track record, and financial transparency.
[See: 7 Best Tech Stocks to Buy for 2017.]
But if you’re looking for the best penny stocks to buy? Sorry, they don’t exist.
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Looking for Penny Stocks to Buy Is a Fool’s Errand originally appeared on usnews.com