You won't find many people who don't like bargains, and that's what mostly makes penny stocks so appealing -- at least from the outside looking in. Penny stocks, generally defined as stocks priced less than $5 (it used to be $1), may seem lucrative, but as with most things, if it seems too good to be true, it probably is.
Stocks, in general, are one of the risker types of investments, but penny stocks especially pose more risk to investors. It can be tempting to see a stock for $3 and think, "well, all it has to do is increase by $1, and I'll make a 33% return." But, there's a reason penny stocks are what they are: The business often warrants it. Penny stocks are usually companies that have limited resources, are more strapped for cash, and are more prone to volatility.
On their best day, penny stocks are small companies with a high upside if the businesses pan out. On their worst day, penny stocks can be a one-way ticket to $0 per share.
Cheap doesn't equal value
One thing investors need to keep in mind is that cheap and undervalued aren't synonymous. A $3 stock could be overvalued, just as a $3,000 stock could be undervalued. Price itself isn't enough to determine if a stock is a good value.
It's better to compare the company to similar companies in its industry, preferably using price-to-earnings (P/E) ratios. A company's P/E ratio tells you how much you're paying for a dollar of its earnings. If a company's P/E ratio is drastically lower than comparable companies, it's a good chance it's undervalued, and vice versa.
There are plenty of undervalued companies out there. In fact, a lot of people make a good living by taking the time to find them. However, one of the quickest ways to lose money is assuming penny stocks are priced that low because the market has somehow managed to overlook all of these companies.
If you're investing in a company, it should be because you believe in the long-term potential of the business, not because the price is "cheap" enough to warrant the risk.
Penny stocks don't usually fit into long-term portfolios
Due to the speculative nature of penny stocks, they're often not really a fit for a sound long-term investing strategy. Investors focused on the long term should look for a solid mix of stability and proven track records (usually large-cap stocks) and high growth potential (usually small-cap stocks).
You don't have to rely on penny stocks to make up your small-cap stocks, though; you can use small-cap index funds. Small-cap index funds may not have the hypergrowth potential of an individual stock, but they're also less risky because the risk is spread out among many companies.
Thanks to the introduction of fractional shares, penny stocks also don't have quite the same draw. Back in the day, if you wanted a share of a large company, it could cost well into the hundreds or thousands. Now, with as little as $1, you can grab your favorite stocks, regardless of their price. Instead of essentially gambling your money with penny stocks, you're likely better off putting it into sound businesses with proven track records.