Penny stock investing — that is, buying very small companies that trade for only a few cents per share — is becoming an increasingly popular way to invest. After all, a rising tide lifts all boats, and the big tailwind for the stock market since the 2009 lows has also lifted microcap penny stocks, too.
In fact, a May report in The Wall Street Journal showed that trading volume in so-called “over the counter” stocks — that is, smaller companies that don’t trade on the NYSE or Nasdaq — have jumped 40% in 2014.
But penny stock investing is not as easy as it sounds.
For starters, there are plenty of investments out there that trade for a cheap share price for a reason; picking up a battered company with negligible profits can be a risky bet.
But even worse is the potential of OTC stocks and penny stocks to be a playground for scam artists.
Penny Stocks – They’re Not All Scams, But…
The FBI just conducted a massive sting operation to net penny stock fraudsters. And while “agents had worried they had made the terms of the scam so clearly illegal, to try to avoid claims they were unfairly entrapping people, that no one would be caught” according to the Wall Street Journal, one member of the operation said they found so many eager criminals that “we should have set up a turnstile.”
This is the kind of world you live in if you invest in penny stocks.
Last year, prosecutors charged a sophisticated penny stock scam ring after it allegedly fleeced investors out of $140 million because they believed in a “revolutionary” fertilizer company called Resource Group International. These unwitting penny stock investors were swept up in the narrative of a game-changing company and never bothered to check into its financials.
Another common tactic of penny stock scam artists is to put some star appeal behind their company to juice interest. These kind of celebrity endorsements are a huge red flag.
Consider Daniel “Rudy” Ruettiger of Notre Dame walk-on fame paid $382,866 (though did not have to admit guilt) in a settlement for his antics in a tiny sports drink company called, obviously, Rudy. Separately, Rapper 50 Cent talked up a penny stock he owned on Twitter to gin up its returns.
So how do you mitigate your risk in such an environment, should you decide to buy cheap stocks or penny stocks?
It all starts with reading.
Every investor must do his or her own research and look seriously at cheap stocks before simply buying in based on a narrative of once-in-a-lifetime opportunities. Because if you’re buying simply because of share price alone — or because of an overhyped recommendation you read somewhere — you’re not getting the whole story.
This is a huge risk with any investment, but particularly with penny stocks.
So do your research, look into the financials — if there are even any financials to speak of — and make an informed decision.
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. As of this writing, he did not hold a position in any of the aforementioned securities. Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP.