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What Are Penny Stocks and Are They Safe?

Penny stocks are stocks that typically trade at less than $5 per share. They're also often called micro-cap stocks, nano-cap stocks and over-the-counter (OTC) stocks.

Although there are certainly cheap stocks bought and sold on major exchanges, what's traditionally thought of as a penny stock won't be common on the New York Stock Exchange or NASDAQ. Instead, they're traded through the OTC Markets Group or OTC Bulletin Board.

Is It a Good Idea to Invest in Penny Stocks?

Penny stocks are tempting because they're cheaper per share than popular stocks that trade on major exchanges. Because they have much lower prices, the potential upside can also be greater.

But investing in OTC stocks can be incredibly risky, and they aren't considered a good investment for most investors. Here's why.

Limited Information

One of your best tools as an investor is information. The more you know about a company, the better your chances of determining whether it's a good investment.

There are a lot of factors that go into determining a company's share price, but a big part of that is the company's financials. Unfortunately, not all companies with penny stocks are required to file the same financial reports with the Securities and Exchange Commission that companies traded on the big exchanges do. Specifically, this applies to companies that are listed on the pink sheets, an OTC stock listing service.

With little to no information about the company's performance, it becomes a major challenge to determine the value of its stock, and whether it presents a good investment opportunity.

A Lack of Liquidity

Stocks traded on major exchanges have a high level of liquidity, which means when you buy or sell a stock, there's almost always someone to sell to or buy from you.

In contrast, penny stocks trade infrequently. As a result, it's possible to purchase a penny stock then not be able to sell it. If you can't find a buyer, you may be forced to reduce the price until it becomes appealing enough for someone to step forward and buy it.

High Probability of Fraud or Bankruptcy

This lack of liquidity means penny stocks are susceptible to "pump and dump" schemes. In these scenarios, scammers hype up a particular stock, then buy large amounts, driving up the price of the shares. As soon as other investors race to buy shares to get in on the upswing, the scammers sell their shares at the higher price and pocket the gain.

Once the scammers cash out, the market quickly recognizes that the stock is overvalued, and the remaining shareholders are forced to sell at a loss.

In addition to fraud from investors, another potential issue comes from the companies themselves: Many of these firms are relatively new with no track record, or they have a very poor performance history. In some cases, they may even be approaching bankruptcy. Again, because there's very little information on many of these companies, you may end up buying shares only to lose your entire investment when the company collapses.

Penny Stocks Are No Longer Necessary for Small-Time Investors

Because of their low prices, penny stocks attract inexperienced traders who don't have a lot to invest. But with the advent of fractional shares, it's no longer necessary to take on the additional risk that penny stocks pose.

Fractional shares allow you to purchase a portion of a share in a company based on how much you want to invest. With Amazon, for instance, you don't have to have the roughly $3,100 it would take to buy a share in the company (as of January 2021). Instead, you can purchase a fractional share based on your ability to invest. With some brokerages, that figure can be as low as $1.

While you won't own a whole share, you'll still be able to participate in the stock's ups and downs. Your share in gains and losses remains the same in terms of percentages but different in actual dollars.

For example, if you buy one share of Apple stock at $130 and the share price increases by 10%, your gain is $13. In contrast, if you own $5 worth of Apple stock via fractional shares, your gain will be $0.50.

Many brokerages offer fractional shares, including Charles Schwab, Fidelity, Robinhood and more.

Additional Places to Invest Your Money

In addition to fractional shares in individual stocks, you've got plenty of other options that may be safer, and even more lucrative, than penny stocks. Depending on how much you have to trade, you may also have other options, including:

Of course, it's a good idea to do your research on investment opportunities before you pull the trigger. With individual stocks, for instance, there are different categories, such as large cap, small cap, growth and value. Each of these categories has its benefits and drawbacks, and it's important to understand them to ensure you make the right decision, especially when you're just starting out with investing.

Additionally, it's a good idea to make sure your finances are in enough order that it makes sense to begin investing. For example, you'll want to make sure you have a robust enough emergency fund that you can weather rainy days. It's also generally a good idea to pay down high-interest debt because the interest rates are often higher than the expected return of the stock market.

As you invest, keep your long-term financial goals in mind. It's a good idea to maintain a retirement account separate from the investment accounts you manage, so you don't put all your eggs in one basket. Managing your own investments can be worthwhile, but it can also be riskier than a professionally managed 401(k) or IRA account.

Consider Financial Planning Help

Investing in stocks and other securities can be an exciting prospect, but doing the research and developing the right strategy can take months or even years. What's more, it can be time-consuming to manage those accounts, whether that means timing your purchases or knowing when to sell.

The best way for you to invest can depend on many factors, including your age, income, investment knowledge, capacity to invest, risk tolerance and more. If you need help, consider working with a financial advisor. An advisor can help you by learning about your situation and goals and providing advice on how to achieve them. The financial planning process is often comprehensive, including your entire financial plan, not just the investment portion.

Many financial advisors can also do some or all of the work of investing your money on your behalf. That said, these advisors can be expensive.

Another option is to consider opening an account with a robo-advisor. Robo-advisors are investment management companies that use algorithms to create and manage your portfolio. There's very little human interaction involved, though some robo-advisors have a team of advisors you can speak with.

Robo-advisors are typically much cheaper than hiring a financial advisor. But if you prefer a more personalized service based on your overall financial plan, you likely won't get what you need from one. They also give you little control over what's in your portfolio, which can be challenging for some.

Do Your Homework to Find the Right Investment Strategy for You

There's no one-size-fits-all approach to investing. While penny stocks do get attention from traders, they're generally not the best way to go for inexperienced investors. Instead, look for other opportunities to invest your money based on how much you have to invest and your short-, mid- and long-term goals.

Also, consider enlisting the help of a robo-advisor or human advisor, who can do much of the legwork for you.

Finally, try to avoid prioritizing investing over fundamental financial planning and long-term financial goals, which can include keeping a budget, building an emergency fund, paying off debt, saving for retirement, maintaining enough insurance coverage, monitoring your credit and more. The best financial approach is often a comprehensive one.