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Why Penny Stocks Are for Losers

Penny stocks are bad news for investors. Indeed, they’re not suitable for investing at all. These tiny, volatile securities are the playthings of speculators at best and scam artists at worst.

Penny stocksPenny stocks trade on the over-the-counter market, also sometimes referred to as the Pink Sheets (OTC stock quotes were once printed on pink paper).

It’s a lightly regulated venue, which leaves shareholders exposed to much greater risks than the major markets.

For one thing, reporting requirements don’t amount to much. Another big liability of penny stocks is that there is typically a thin market for shares. And the lack of oversight means it’s easier for penny stock companies and sellers to lie.

Throw in the lack of liquidity, and you have the ingredients for a pump-and-dump scheme.

The OTC market is also less efficient. Major venues such as the New York Stock Exchange and Nasdaq employ centralized trading. Inversely, there is no single exchange for penny stocks. Instead, the OTC connects buyers and sellers over a computer- and telephone-based system.

And, remember, most market participants in penny stocks aren’t looking for quality investments. They just want to scalp the other side of the trade.

True, there are plenty of big, legitimate companies trading OTC. Samsung (SSNLF), Volkswagen AG (VLKAY) and LVMH Moët Hennessy Louis Vuitton S.E. (LVMUY) are just three massive names that list over-the-counter in the U.S.

That’s fine. Foreign companies opt for the OTC market because of cost and convenience. For one thing, OTC stocks aren’t required to file periodic or audited financial reports. That can be a benefit to companies in the European Union, which don’t have to disclose numbers every three months like their U.S. peers. It also saves a foreign issuer the cost of translating reports into Generally Accepted Accounting Principles, which much of the rest of the world doesn’t use.

But although these securities are OTC, they are not penny stocks. A typical penny stock is a highly risky micro-cap stock with a market capitalization of under $300 million, or a nano-cap with a market value of less than $50 million.

Penny Stocks Come With Official Warnings

Federal and industry regulators make it abundantly clear that messing around with penny stocks is foolish. As the Securities and Exchange Commission warns investors (emphasis theirs):

“Penny stocks may trade infrequently, which means that it may be difficult to sell penny stock shares once you own them. Moreover, because it may be difficult to find quotations for certain penny stocks, they may be difficult, or even impossible, to accurately price. For these, and other reasons, penny stocks are generally considered speculative investments. Consequently, investors in penny stocks should be prepared for the possibility that they may lose their whole investment (or an amount in excess of their investment if they purchased penny stocks on margin).

As mentioned above, penny stocks are also the preferred vehicles for pump-and-dump schemes. (Anyone here see The Wolf of Wall Street?) Too-good-to-be true “investment” opportunities used to show up as unwanted faxes. Now they travel as email spam. These unsolicited offerings should always — always — be ignored. Forget about “hot stock tips” too, especially from strangers.

Heck, in some cases penny stocks don’t even represent equity in a real live business. They exist only as a rip off. The Financial Industry Regulatory Authority makes this point quite clear. Among the other risks FINRA outlines, the industry’s self-regulatory organization has this to say:

“Be wary of companies that have no operating history, few assets, or no defined business purpose. These may be sham or ‘shell’ corporations. Read the prospectus for the company carefully before you invest. Some dealers fraudulently solicit investors’ money to buy stock in sham companies, artificially inflate the stock prices, then cash in their profits before public investors can sell their stock.”

And even if you don’t step into a con, the aforementioned lack of liquidity makes playing with penny stocks just plain dumb.

Here’s FINRA again:

“You should be aware that you may lose part or all of your investment. Because of large dealer spreads, you will not be able to sell the stock immediately back to the dealer at the same price it sold the stock to you. In some cases, the stock may fall quickly in value.”

Sure,OTCMarkets says more than 400 securities have been “up-listed” to a major exchange in the last five years or so.. That sounds pretty good. In some cases, those penny stocks enjoyed big gains.

Penny stock promoters love to push this fact, but know this first: There are more than 10,000 securities trading OTC.

Good luck with that up-listing.

Trading penny stocks is nothing more than a form of gambling, with crummier odds than you get from a casino. Managing risk with serious securities is plenty difficult as it is. Why wave your hard-earned cash over an open flame on purpose?

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

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