Do you remember Leonardo DiCaprio's character in The Wolf of Wall Street? He was a crass equities trader who took advantage of innocent investors by selling them shares of risky (and often worthless) penny stocks -- and made a fortune off the investors' naive lack of understanding of what he was doing. It's based on real events, and many real investors make the same mistakes.

Penny stocks are securities that sell between $0.01 and $5 a share. Many investors find this appealing because the stocks are cheap, and if they're just starting out and don't have a lot of cash to invest, they can buy lots of shares. The belief is that if a penny stock happens to make it big, a lot of money can be made.

Investors who have many years until retirement or who are trying to catch up for starting to save late are often looking for ways to make money quickly. Therefore, they're willing to take on higher risk to meet their goals. But are penny stocks really a good choice for your retirement portfolio?

Several pennies and a magnifying glass on a paper that says Penny Stocks

Image source: Getty Images.

Accumulating wealth

When you're accumulating assets for your senior years, you're looking for equities that will continue growing and paying dividends (whether directly or through price appreciation). Stocks with stellar financials, great products, and unlimited future prospects often fall into that category.

Because penny stocks are inexpensive, they seem like a reasonable risk to take. After all, you can buy 1,000 shares of a $5 stock for $5,000, and if the stock appreciates, you'll make money with that number of shares. But caveat emptor: A low price doesn't necessarily mean you're getting a bargain -- especially if the company goes out of business before you see it appreciate.

Beware of penny stocks

The problem with penny stocks is that they come with very high risk -- and that's something most investors want to avoid when investing for their senior years. Here's why:

  1. Penny stock companies often haven't proven themselves, or have products that haven't shown they'll be successful.
  2. They are speculative companies, and only a very small percentage find their way to establishment success.
  3. They don't trade on major exchanges like the NYSE or the Nasdaq, so they aren't subject to the financial requirements necessary to qualify for inclusion in the major indexes.
  4. Because penny stocks are small and not widely followed, it's hard to research these businesses or get financial information on them.
  5. The penny stock industry has a history of fraud, as some unscrupulous brokers (like the character in The Wolf of Wall Street) will lie, cheat, and scheme to get you to buy the stock -- and then sell their shares when the stock is high, causing the stock to plummet and you to lose your money. That's called a "pump and dump" scheme.

Why penny stocks are tempting

With all these dangers, some investors still buy penny stocks. They like that the stocks have a low share price, letting them buy large numbers of shares. And they dream that their stock will hit it big and give them a huge profit. 

The latter may sound nice, but an overwhelming majority of penny stocks fail. As for the former, you no longer need to have a lot of money to buy into great companies with high stock prices -- you can do so by buying fractional shares.

The fractional share alternative

Beginning in the spring of 2020, major brokerage houses like Schwab and Fidelity started allowing their customers to buy fractional shares of a company. How does that work? Let's say you have $1,000 to invest. You've wanted to buy shares of Amazon.com for a long time, but it's just too darn expensive at $3,250 a share.

With fractional shares, your broker can take that $5,000 (that you were going to invest in penny stocks) and buy about 1.5 shares of Amazon. That doesn't seem like much, but look at it this way: If the stock increases by 10%, you'll still have the same return, whether you own 1,000 shares of a penny stock or 1.5 shares of Amazon.

But which company do you think has a better chance of achieving that type of return -- a totally unproven and unknown company, or the online e-commerce leader that's still growing like gangbusters?

If you're saving for retirement, you want to invest in companies that are well-established in their industries and have proven their stability and ability to grow. A company like Amazon has shown it's here to stay and has more growth in its future. As for a penny stock company? Well, who knows. And when it comes to your retirement, you want companies that will still be there and blossoming when it's time for you to leave the workforce.

Avoid penny stocks. They're just too risky for your retirement savings. And if you're diligent in your investing and hold great companies for the long term, you can accumulate great wealth. Maybe not as much as Leonardo DiCaprio's character -- but you'll be enjoying life on the beach, not a lifetime in prison.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.