Penny stocks are having a moment right now.
Of the top 10 most active stocks in mid-January, stocks trading at less than $1 per share took up six spots on the list, according to data gathered by Joseph Saluzzi, co-founder and co-head of equity trading at Themis Trading. Those six stocks alone made up around 18% of total stock market volume.
Penny stocks are generally considered among the riskier types of investments, and it's rare to see them make such massive waves in the market. But does this newfound popularity mean they're good investment opportunities?
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What are penny stocks?
First, it's important to understand what penny stocks are. Penny stocks are generally defined as stocks that trade for less than $5 per share, although many trade for less than $1 per share.
Their low price tag can be appealing to new investors looking to dip their toes in the market without spending large sums of money, as well as day traders trying to make a quick buck.
However, penny stocks can carry substantial risk. Typically, companies that issue penny stocks are small businesses. While this can be an opportunity for investors to earn sizable gains as the company grows, it also means penny stocks are potentially volatile investments that can experience intense price fluctuations.
In addition, because the companies tend to be smaller and less stable, it can be more difficult for investors to research the stocks before buying. These businesses don't have the history that larger corporations listed on the major stock exchanges have, so it can be tough to tell whether the company is strong financially.
Finally, penny stocks often have limited buyers and sellers -- making trading more challenging. Say, for example, you invest in a penny stock with a price of $0.50 per share. A week later, that stock has increased to $2.00 per share, and you're ready to sell and make a hefty profit. You put in a sell order, but there are no buyers. Your order sits there until someone wants to buy. Because penny stocks can fluctuate wildly in price, the stock price could plummet by the time you're finally able to sell.
Where to invest instead
Although penny stocks are hot right now, that doesn't mean they're smart investments. They're still volatile stocks. Unless you're willing to tolerate high levels of risk, it's best to avoid them.
Fortunately, there are plenty of other investments that can offer less risk with higher long-term rewards.
One option is exchange-traded funds (ETFs). ETFs are large collections of stocks grouped together into a single investment. One of the major perks of investing in an ETF is that no matter what industry you're interested in, there's an ETF for you. There are broad market ETFs that track stock market indexes like the S&P 500 or the Dow Jones Industrial Average. Then there are niche ETFs that contain stocks from the tech industry, healthcare industry, hospitality industry, or even the pet care industry.
Also, because ETFs are groups of stocks, investing in a single ETF can instantly diversify your investments and limit your risk. Each ETF may contain dozens or even hundreds of stocks, and if a few of those companies don't perform well, it won't tank your entire portfolio.
If you'd rather invest in individual stocks, blue-chip stocks are safer bets than penny stocks. Blue-chip stocks are often strong and well-established companies with a proven track record of financial success. These companies are usually household names, such as Amazon (AMZN -2.40%), Apple, Disney, and Coca-Cola. Although blue-chip stock prices are higher than penny stocks, they're much more stable and carry significantly less risk.
No matter where you choose to invest, be sure you're taking a long-term approach. Penny stocks can be appealing when it comes to short-term gains, but they're often not sustainable over the long run. When in doubt, consider legendary investor Warren Buffett's advice: "Be fearful when others are greedy."
