A lot of new investors are drawn to penny stocks. It’s easy to see why these instruments might seem appealing at first glance: because penny stocks by definition sell for $5.00 or less per share, nearly anyone can buy in. And when you buy shares for only a few cents, they only have to gain a few cents for the value of your investment to double!
Unfortunately, penny stocks are typically a bad idea, especially if you’re new to investing. Here, we’ll explain why penny stocks are actually more like gambling at a casino than investing in the stock market and give you the lowdown on fractional shares, which let you invest in blue chip companies even if you can’t afford a single share.
Let’s start with the reasons why penny stocks can be a bad idea.
1. They’re volatile, difficult to research, and susceptible to manipulation and scams
In other words, they’re risky – but “risky” doesn’t quite convey they extent of the danger here. After all, all investments involve risk. But with penny stocks, the risks can be greater than your typical stock investment.
Let’s break down these three features to understand why penny stocks don’t make sense for most investors:
- They’re volatile: Penny stocks tend to have a small market cap, which means that movement from just a handful of traders can cause their price to swing wildly. This means the price of a stock can move significantly more than the fundamentals of the underlying business.
- They’re hard to research: Unlike stocks listed on public exchanges like the NYSE, penny stocks don’t have to publish regular financial information, which means the typical trader has very few resources to help them assess the performance and outlook of the company. This is a problem because stocks are supposed to represent the underlying value of the company they’re attached to; if investors have no information on the company’s performance and financials, that value assessment is largely speculative.
- They’re susceptible to manipulation and scams: Because of the two above characteristics, penny stocks are also more susceptible to manipulation and scams than other types of stocks. Maybe the most common scam, the “pump and dump,” involves a few investors spreading hype about a company and buying a lot of its shares to send prices up (the pump), then selling them quickly, at a profit, to unsuspecting investors (the dump). After this maneuver, buyers may be left holding stocks worth very little or nothing, as the underlying value of the business doesn’t back up the hyped-up price.
These reasons should be enough for anyone to steer clear of penny stocks, but if you still aren’t convinced, consider the second major point against them:
2. They’re highly illiquid
Remember: stocks aren’t actual money. You can’t pay for your groceries in stocks. But for stocks listed on the NYSE and other major exchanges, liquidity is high, meaning that any time you’d want to sell a given stock you hold, it’s more or less guaranteed that there would be a buyer.
That’s called “liquidity.”
Penny stocks, however, are notoriously illiquid. In practice, that means that even if you manage to buy a bunch of shares low and the price soars, you may not be able to find any willing buyers. So while the value of your stocks on paper might have increased, you can’t turn that theoretical value into actual value unless you can convince someone to buy.
And because of the known volatility of these instruments, there’s a good chance your potential buyers will want to wait until the price goes down again to buy. Or else you’ll be able to sell a small amount at the high price, therefore limiting your overall gains (if any).
Or maybe you’ll be able to sell all your holdings, but probably not for their high nominal value. In other words, you can never assume the theoretical value of your penny stocks will be translatable into actual value.
Another consideration: penny stocks are not listed on the NYSE. The companies they represent haven’t met the minimum standards that the NYSE requires for listing – and this means you can’t trade them on that exchange. Instead, you have to go over the counter (OTC), which means trading without an intermediary.
3. They cause tax headaches
There are two reasons why trading penny stocks can be a pain at tax time.
First, the volume of shares you likely buy and sell can make it hard to keep track of how much money you owe taxes on.
Second, if you’re holding your penny stocks for less than a year, any gains you earn will be taxed at your income tax rate rather than at the long-term capital gains rate (which is lower for most people).
Of course, there are almost always special cases with taxes, so if you trade penny stocks you’ll have to investigate the details of your situation to make sure you file properly. Regardless of your situation, though, penny stocks don’t come with built-in tax efficiencies as ETFs and other instruments do.
4. SEC and TAF fees will be a larger portion of your proceeds
Every time you sell a security, the SEC and FINRA charge small fees to help offset the costs of regulating and overseeing the market. These fees are based either on the number of shares you sold (TAF) or the dollar amount of your transaction (SEC) and are rounded up to the nearest penny.
On large-dollar-amount sales, these fees don’t have much effect on your overall gains (and the TAF fee is capped at $5.95), but if you’re trading penny stocks, that rounding can account for a larger portion of your overall gains.
5. They’re hard to keep track of
If you’re already investing with M1, you know that we structure investment portfolios as Pies: each slice represents a different investment type or group. This helps you visualize the balance of your portfolio and make sure it matches your risk tolerance, your belief system, and your goals.
If you’re investing in penny stocks, though, you could easily add a dozen slices just to your “penny stock” allotment. And that’s a lot to keep track of: that’s a dozen individual companies whose financial performance and growth potential you should be actively tracking to guide your buying and selling decisions – without much verified information.
Even if you have the best intentions with penny stocks, it’s easy to lose track of one or more of your holdings and be taken off guard by an unexpected dip that significantly reduces the value of your investment.
Penny stock alternative: fractional shares
The good news is that there is a much better alternative to penny stocks for investors: fractional shares.
Fractional shares are exactly what they sound like: a piece of a full share of a company. They’re a handy tool because they let even investors who don’t have millions of dollars…
- Invest in high-growth companies with sky-high share prices (think Amazon, whose shares were going for more than $1,800 as of this writing).
- Maintain desired risk allocations (i.e., you don’t have to have a portfolio that’s more or less Amazon-heavy than you’d like because you had to buy whole shares).
In other words, fractional shares let you invest relatively small sums in established companies with public financials and highly visible track records of performance. Compare that to an investment in a penny stock, which is considered highly speculative because the firms that issue these stocks are usually smaller and subject to fewer financial regulations.
And because our goal at M1 is to let you maximize the performance of every dollar you have, we structure our fractional shares to be as investor-friendly as possible:
- We divide shares into 100,000 parts to make it possible to get the exact amount of a given company that suits your portfolio balance.
- We don’t charge commissions on fractional shares.
- We sell every fractional share at the market price (i.e., if shares are selling for $1,000, we’d sell you 1/10 at $100).
In other words, you can invest in top-performing companies without paying a premium to do so. We believe that’s the best way to enable our customers to enjoy their desired return on their investments, and we exist to help people live better by actively engaging with their money.