What Are Penny Stocks? - January 2013

"What are penny stocks?" is a question often heard by stock brokers and portfolio managers from novice investors who've heard the buzz about penny stock investing and want a financial windfall of their own.

In general, if a micro-cap stock trades below $5, is not listed on a major exchange, and has low liquidity, it's considered a traditional penny stock.

Most penny stocks are quoted over the counter on either the Over-The-Counter Bulletin Board (OTCBB) or in the Pink Sheets. While some stocks in the broader exchanges like the New York Stock Exchange or Nasdaq trade for less than $5, the sentiment among many investors is that these are not true penny stocks.

Penny stocks also trade infrequently - and this illiquidity can make it difficult to sell penny stocks once they have been purchased.

The U.S. Securities and Exchange Commission also defines penny stocks to include some private companies with no active trading market. Finding quotations for penny stocks can be a difficult proposition, according to the SEC - which means accurately pricing some penny stocks can be nearly impossible.

These defining criteria can make purchasing penny stocks a risky proposition for any investor.

What Are Penny Stocks' Risks?

Because penny stocks trade on the OTCBB or Pink Sheets, investors are often concerned with the reporting standards for penny stock companies. The OTCBB requires companies to stay current with their SEC filings, but that bare-bones requirement is a far cry from the reporting standards of the larger exchanges. The Pink Sheets does not enforce any listing requirements.

That can make penny stocks a breeding ground for dishonesty and securities fraud. One of the more popular scams is the "pump-and-dump," in which dishonest brokers hype up the value of a security and then sell it to unsuspecting retail investors at an inflated price.

Another pitfall of penny stock investing is the stocks' illiquid nature. If an investor purchases a large quantity of penny stocks and is unable to unload them quickly, that investor could be left holding a lot of useless stock.

In an attempt to inform investors of these risks, the SEC has made it a legal obligation for all stock brokers to notify clients of penny stock investing risks before selling any shares in such stocks.

The Massive Gains from Penny Stocks

So why would anyone invest in penny stocks after learning all the risks? Simply put, the potential for huge gains is undeniable...

Penny stocks can be wildly volatile. Not every penny stock is going to be a home run - and in fact, many strike out - but the right penny stock investment could bring percentage gains in the thousands.

One such example is software company Concur Technologies Inc. (Nasdaq: CNQR). After the tech bubble burst in the late 1990s, Concur traded as low as $0.31 per share in early 2001. CNQR is currently worth more than $101 per share. That's an increase of more than 32,000%.

Energy drink producer Monster Beverage Corp. (Nasdaq: MNST) is another example; its stock value increased from $0.69 in 1995 to more than $67 a share today. Those who got in early on that 9,600% gain are presumably okay with the risk they initially assumed.

If you're risk-averse, penny stock trading is probably not for you. The potential for huge gains is irrefutable, but so are the numerous pitfalls.

Investors should only put money into penny stocks that they are comfortable with losing. Making penny stock investing the foundation of your portfolio is not only dangerous, it's downright foolish.

Taking an inexpensive flyer on a few penny stocks, however, has the potential to bring life-changing gains to your portfolio.

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