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Small stocks can offer opportunities for big rewards. But with really small stocks -- also known as penny stocks -- the risks involved often outweigh any benefits.
Penny stocks aren't the kinds of shares that can make you a millionaire. You'll find many of them trading for less than $1 apiece -- hence the name. Unfortunately, they usually fetch such tiny prices for good reason. Typically, penny stocks have relatively few shares outstanding, making it easy for fraudsters to buy shares, hype up the company, and thereby drive up the price as others flock in. Then they'll sell their shares, sending the stock cratering again -- a classic example of "pump and dump."
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Even if you know that, you can still get lured in by the hype. Here are some choice excerpts from a dubious email that recently urged me to buy into an energy company:
- The company supposedly controls some 150 square miles of "key petroleum leases" near the oil-rich North Sea. Note that the company's not boasting that it's actually discovered oil -- just that it's near the place where billions of barrels "discovered by BP (NYSE: BP ) and now operated by Apache (NYSE: APA ) " were found.
- In a single paragraph, the company claims that its four license blocks are estimated to contain a prospective resource of approximately 236 million barrels of oil. This "pending discovery-size" is apparently good, because it puts the company's supposed prospective oil holdings in the "highest potential" areas in the U.K. Did you catch any certainty there? Any specificity? Any proven assets?
- The company is actually producing oil in Texas, via a lease near some oil discovered by Royal Dutch Shell (NYSE: RDS-A).
That's all classic penny-stock stuff. The hypesters get you excited with possibilities -- possible cures for cancer, possible gold mines, possible billions of barrels of oil. But why take such wild chances with your money, when you can invest in proven companies that can dominate their peers?
To check the email's claims, I looked up the company. Until recently, you wouldn't have found much information on it. Before the email spurred investor interest, the stock went days without trading at all. Even now, days where more than 50,000 shares trade are rare. At just more than $1 a share, that's not very significant -- especially when you compare it to the hundreds of millions of shares traded daily for active stocks such as Citigroup (NYSE: C ) and Bank of America (NYSE: BAC ) .
Don't let yourself be tempted. While the stock hyped in the email I received has skyrocketed since this marketing push, in the long run I think it'll more likely trade for $0.10 than $10. Focus instead on powerful companies with compelling advantages.