Penny stocks are among the most affordable types of investments out there. These low-priced stocks often trade for less than $1 per share. Their low cost makes them attractive for investors trying to limit their spending, since they can easily buy hundreds of shares without breaking the bank.
Although I believe investing in the stock market is one of the best ways to create wealth, I'm staying far away from penny stocks. Here's why.
1. They're harder to research
One of the most critical elements of investing involves researching the stocks you're interested in buying. Understanding the company's fundamentals can help you gauge whether the organization is financially healthy and shows growth potential.
Companies that issue penny stocks, however, are often smaller businesses that don't have the extensive track record that you'd see with larger corporations. This can make it difficult or even impossible to tell whether the company is healthy or not. Investing in a shaky business is a recipe for disaster.
2. They're more volatile
Because these businesses are smaller, penny stocks often experience substantial price fluctuations. Smaller companies tend to be more volatile as they find their footing and experience growing pains. Their stock price often reflects that turbulence.
These price swings make penny stocks incredibly risky. Your investments could plummet in value overnight, and not all investors (myself included) have the stomach for that much volatility. There's also a greater chance that smaller businesses will fail, which could sink your investments.
3. They're often harder to sell
In order to sell penny stocks, you need to have a buyer. Sometimes, though, there aren't many buyers looking for particular stocks. This can make penny stocks harder to sell, which is especially dangerous considering how quickly their prices can fluctuate.
Say, for example, you buy 1,000 shares of stock for $1 per share. You're concerned the price is going to drop, so you want to sell. If you can't find a buyer, though, you're stuck with the stock. Say the price drops to $0.50 per share by the time you're finally able to sell. At that point, your shares are worth half what they once were. If you sell all your shares, you've just lost $500.
4. There are better options out there
I avoid penny stocks because there are other options that are just as affordable but carry substantially less risk.
Fractional shares, for example, are great for investors on a budget. When you invest in fractional shares, you're buying a small portion of a single share of stock. Because you're not buying a full share, it's much more affordable. You can also buy shares of big-name stocks like Amazon, Apple, or Tesla for as little as $1.
Exchange-traded funds (ETFs) are also excellent. With an ETF, you can invest in a bundle of stocks at once. Some ETFs track broad-market indexes, like the S&P 500, while others focus on niche industries. They also provide instant diversification; instead of investing in a single stock, you're investing in dozens or even hundreds of stocks simultaneously.
Investing in penny stocks can be tempting, especially if you don't have much spare cash to invest. But there are better options available that aren't nearly as risky. By avoiding penny stocks, you can limit your risk while still making a lot of money in the stock market.