Penny Stocks, Explained

Ever wonder what penny stocks are, and whether they really cost a penny? Read on.

In the days of yore, penny stocks often did cost only a penny per share. Today, any stock selling for less than $5 or so per share might be considered a penny stock. They often represent companies with less-than-stellar track records that nonetheless promise great success around the corner. (Revolutionary gold-deposit detectors! A cure for the common cold!)

Penny stocks are dangerous, because people think low prices mean bargains, and assume that they'd be better off spending their $500 on 300 shares of a penny stock than on 20 shares of, say, McDonald's (NYSE: MCD  ) .

Believe it or not, a stock might be grossly overvalued at $1.50 per share, but significantly undervalued at $150 per share. Many people don't understand this, and they often gravitate toward the $1.50 stock, thinking it'll more quickly double in value. That's a risky assumption, though. Your performance when holding a stock really depends on the stock's intrinsic value, not its trading price; the price at which you buy into the stock; and the amount of money you invest, not the number of shares you own.

Imagine that you buy 100 shares of a $0.60 stock and one share of a $60 stock. You'd spend $60 for each investment. (This is an example, with commission costs disregarded.) If each investment doubles in value, you'll have 100 shares of a $1.20 stock, worth $120, and one share of a $120 stock, worth $120. You would have gained no advantage by buying the lower-priced stock. A $60 or $25 or $100 stock is more likely to double in value -- and hold its value for the long term -- than a typical penny stock is.

Most penny stocks are selling for a low price for a reason. They occasionally get hyped and soar briefly, but they usually plummet back to earth. Steer clear of the pennies.

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