Don't ask me why I did it, but I clicked on an advertisement on Yahoo! Finance yesterday. The tag line for ad: "Penny stocks are the secret to buying happiness." It sent me to an advertorial website (which is an advertisement disguised as real content).
I didn't really have time to be randomly clicking around, but when I saw the advertorial headline of "The Advantages of Buying Penny Stocks" -- which I could only assume meant beyond the original promise of being able to buy happiness -- I couldn't help but read on.
Fun with "facts"
The advertorial started off well enough, stating that "a penny stock is a common stock trading at five dollars or less." Fact! Unfortunately, it only went downhill from there. Let's take a closer look at a few of the other ideas that this penny-stock pitch tried to float.
- "Penny stocks are sold at such low prices that they entice many investors, particularly first-time investors." This is actually a true statement. However, just because something looks attractive at first blush doesn't mean that it's a good idea. To many an unfortunate fly, the inner surface of a Venus flytrap looked quite attractive.
- "These low prices allow novices to explore the markets, without risking an extensive amount of money." Yes, as their name suggests, penny stocks have low price tags. But it's important to remember that the brokers that allow you to buy and sell stocks aren't charities -- they charge money for their services and that needs to be taken into account when choosing how much you invest. If, for example, you only want to invest $20, but you pay a $10 commission to buy and another $10 to sell, then you need a 100% return on your trade just to break even with the commissions. If, on the other hand, you're investing a more reasonable amount, your investment options expand significantly. Walgreen (NYSE: WAG), for instance, which is well-known, high-quality company, trades at just over $35 per share.
- "Furthermore, if the stock were to dip in price, the investor will not have lost excessive amounts of money." Wrong! The amount of money that you lose on an investment depends on the amount that you invested in total and the percentage drop in the stock. If you invest $100,000 in a penny stock and it drops 90%, guess what? You just lost $90,000. For most of us, that's pretty excessive.
- "Another advantage to penny stocks is that they are easy to buy." As opposed to what? Buying shares of racehorses? The common stocks of reputable companies are just as easy -- if not easier -- to buy.
But the biggest advantage of all is ... !
OK, so the advertorial may not have done a great job making the case for penny stocks so far, but surely as we reach the final conclusion and the "biggest advantage" of penny stocks we'll be wowed. So what is that biggest advantage? The potential for huge returns!
"The biggest advantage is the potential for very high returns on investment. It is not uncommon for some penny stocks to double or triple in price in extremely short periods of time; something that is nearly impossible for the average stock."
As much as I want to trust this helpful advertorial, I feel the strange urge to fact-check this final push for penny stocks.
To check on this claim, I pulled up the stock performance over the past month for all U.S.-traded stocks with a stock price under $5. Sure enough, there were some penny stocks that had truly astounding performance. Global Water Asset Corp. was up 1,833% for the month while 8000 Inc gained a breathtaking 1,370%.
Case closed, right? Not so fast. While those penny stocks were soaring, others were plunging. Ninety-five U.S.-traded penny stocks lost 70% or more of their value over the past month alone. Do you know how many U.S. traded non-penny stocks lost that much over the past month? Exactly zero.
Maybe even more telling is the fact that over the month, the average return of all of the penny stocks was a 6.2% loss, while the median performance was a 10.4% loss. The S&P 500 posted a 6.4% loss over the same period. Meanwhile, the megacaps in the Dow Jones (INDEX: ^DJI) only lost 5.3% over the same stretch. In other words, on average, penny stocks gave you roughly the same performance as an S&P 500 index fund and underperformed a Dow Jones index fund.
You can't buy me love ... with penny stocks at least
The bottom line is that there is nothing special about penny stocks except for the extreme volatility that could mean huge gains or disastrous losses in the blink of an eye. Far from being a great starting point for novice investors, the low liquidity, low information availability, and high volatility of penny stocks makes them an ideal playground for gamblers and a terrible place for new investors.
No matter what penny-stock pumpers tell you, you're not going to get rich by randomly sticking your hand into the penny-stock candy bowl. But you can put yourself on the right path to investing wisely by learning about how other investors have consistently beaten the market over time.
For greats like Warren Buffett, Benjamin Graham, and Seth Klarman, the formula is simple -- buy stocks when they're priced at less than the underlying company is really worth. Can you find that in the penny-stock world? Sure. But you can also find it among large, well-known companies. Right now I think there is a good selection of blue-chip stocks including Microsoft (Nasdaq: MSFT), ArcelorMittal (NYSE: MT), and General Electric (NYSE: GE) that are trading at very attractive prices.
And if you're looking for even more great stocks that don't require a venture into the wacky world of penny stocks, check out the baker's dozen of stocks that my fellow Fools highlight in the free report "13 High-Yielding Stocks to Buy Today."
