Penny Stocks and Index Funds

Like hard-core bikers sitting down for scones and teatime sips, one would think that penny-stock speculators and index fund investors would be worlds apart. The former aims for feast but more often than not bargains for famine, while the latter is willing to settle for steadier returns based on the general market's buoyancy.

Yet they're not exactly distant relatives. In fact, they may very well be kissing cousins.

The next time that you come across an index fund investor arguing the merits of conservative passive investing, let out a whistle. You can probably stir the pot even thicker by tacking on a phrase such as "looks like someone's sleeping with the pink sheets tonight" or "I never took you for a riverboat gambler."

See, if we're to roll with the traditional penny-stock definition of an equity trading below $5 a share, buying into your fractional chunk of the Standard & Poor's 500 includes 15 of the 500 companies that are trading for less than a fiver.

If you figured that the S&P 500 included only the country's leading and largest publicly traded players, you would be right. However, behemoths fall -- out of favor if not fading away entirely while still maintaining enough girth to stick around the popular market gauge. Remember when JDS Uniphase (Nasdaq: JDSU  ) was going to revolutionize the world of telecommunications? The stock fetched nearly $150 a stub back in 1999. Today it sits humbly at $3.27, still perched on the S&P 500.

Burnt Ciena (Nasdaq: CIEN  ) ? No problem. It still has its S&P 500 membership card even as its shares were changing hands at just $1.93 apiece yesterday. The turbulent shares of Delta (NYSE: DAL  ) are hitting the tarmac at $3.92, but you know which major market index welcomes the beleaguered airline.

From cash-rich and price-poor companies such as Sun Microsystems (Nasdaq: SUNW  ) and Gateway (NYSE: GTW  ) to actively traded bottom-dwellers such as Lucent (NYSE: LU  ) , if you're buying into the S&P 500, then you're buying into an assortment of stocks trading below the $5 mark.

However, that's why we have always broadened the traditional definition of a penny stock to exclude large companies -- and Lucent is indeed a $14 billion company. We also consider the $3 waterline a more telling "sink or swim" indicator than the $5 mark for smaller equities with single-digit prices.

But, yes, you cautious index investor you, what an odd collection of low-priced stocks you're holding.

Do you prefer index funds or actively managed mutual funds? Does the recent trend toward lower index fund expenses find you considering buying into the S&P 500 through a mutual fund? All this and more in the Mutual Funds discussion board. Only on Fool.com.

And if you're interested in doing better than the average performance offered by index funds, check out a free copy of ourMotley Fool Champion Fundsnewsletter. There are some funds out there with solid track records and impressive managers, and we're eager to introduce you to them.

Longtime Fool contributor Rick Munarriz thinks that a penny stock saved is a penny stock burned. He does not own shares in any company mentioned in this story.


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