Are Penny Stocks a Good Long-term Investment?

When looking at whether penny stocks a good long-term investment there are many questions to ask. First, we have to understand what penny stocks are.

Penny stocks are any stocks that trade for less than 1 pound in the UK and $5 in the U.S., according to the Financial Conduct Authority (FCA) and the U.S Services and Exchange Commission (SEC).

1 pound or 5 dollars sounds like the best thing to accumulate, given that many stones have turned into gems in history. One prime example is the Monster Beverage Corporation (MNST), which traded at $0.04 in 1996. In 2020, it traded at around $66, giving exponential gains to risk-hungry investors.

UK penny stocks list on the London Stock Exchange’s (LSE), Alternative Investment Market (AIM), it should be noted that the AIM-listed stocks have no set minimum standards for listing, so penny stocks are not really promising anything here.

We will take an unbiased look at the penny stocks, all their glitter, and all their coal. And then, we will establish whether penny stocks a good long-term investment or not when the main exchanges won’t even list them.

Penny Stocks are Misleading: Is it True?

There are two major misconceptions pertaining to penny stocks that fool investors into believing that penny stocks are a good long-term investment:

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Penny stocks are small-priced stocks, providing immense room for appreciation and huge shares holding. And hence, even a small price fluctuation on the upside can account for a huge percentage of revenue. Investors hence tend to own a huge number of shares of a company that some expect would soon be listed on a major exchange.

But what escapes the eye here is the equal chance of the low-priced, highly volatile stock without authentication to go down. 

The second fallacy that fools investors are that many companies with high-dollar values today were once penny stocks. Many huge fish with stocks of high-dollar values were once small stocks with very low market caps, comparable to penny stocks. Better-known examples include Walmart, Microsoft, and Meta (FB). it is a misleading generalization because firstly, it takes a real-life working idea, a selling plan, or a revolution for a company to grow this big. Not every startup has got that.

Secondly, these huge names were not penny stocks, actually.

An investor who finds penny stocks an easy way up may look at Microsoft and Walmart’s adjusted stock prices on the day they started, and not their actual prices. Stock prices adjusted for splits, for instance, were $0.08 and $0.01 for Microsoft and Walmart, respectively, and the actual prices were $21 and $16.50, which are huge.

Putting your investment in penny stocks for the long term is synonymous with saying no to safety, security, liquidity, and sometimes income or reinvesting dividends. We will be looking deeper to see why penny stocks are not a good long-term investment.

Why are Penny Stocks not a Good Long-term Investment?

Penny stocks are believed to have exponential growth potential. Investors with enough risk tolerance, who are prepared to lose what they invest, find penny stocks quite attractive.

At the same time, penny stocks list on pink sheets for a reason. There are no authentications or valid information available that would buffer the chances of risk. So, an investor with money he is prepared to lose is left with his personal homework to make a high-risk investment. Penny stocks hence come with a shaky foundation, which has dire consequences such as highly volatile prices, low liquidity, and immense room for fraud.

Ups & downs

Lack of History and Information

The key to any successful investment is to base the decision on tangible information, research, and the parameters of stock evaluation. Penny stocks need no authorisations of the financial statement files or make their corporate performance public and available to all the investors.

Anything you get from other sources cannot be used to base an investment choice. The lack of tracking data and information hence is a major drawback with penny stocks. Unless you use stop loss and prepare for the worst outcomes, penny stocks cannot promise much on the safety front.

High Volatility and Low Liquidity

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Price fluctuations in penny stocks are quite frequent and easy. Pump and dump schemes, stock price manipulations, and inherently low stability are some of the reasons. All these factors make penny stocks highly volatile and contribute to their low liquidity.

That is, investment in penny stocks cannot be as readily recovered or converted into cash as with secure assets such as a company stock with a huge market cap.

On August 11, 2020, the stock price of a penny stock, Catalyst Pharmaceuticals Inc. dropped to $3.34 from $4.26, a fluctuation of almost 22% within 24 hours. And throughout the year 2020, it has kept fluctuating between $2 and $5. There are worse stories of various other penny stocks with respect to volatility that people don’t know of.

Low liquidity leads to a situation where once an investor puts an amount in penny stocks, he may get stuck for years. He may have to lower the price in extreme situations to step out.

Sometimes, the investment gets stuck when the big whales of the market artificially hype up a certain stock. When the market cap increases, they sell the stock at a huge price and bag hefty profits. The small fish are left with heavy losses.

Poor Track Records of Microcap Stocks

Micro-cap stocks or penny stocks not listed on credible, huge exchanges do not file their company reports with the SEC or LSE. At the same time, large public companies with high-priced stocks are required to do so. Professional analysts talk about these shares, products, and services and their potential growth and downfall.

Their revenues, market cap, number of shareholders, and stock prices are publicly available. On the other hand, penny stocks are either budding companies or dark horses working slowly without catching any attention from big investors or public investment analysts.

So, on top of low liquidity, no absolute expert opinions, and high volatility, limited research makes these penny stocks a risky investment choice.

Microcap Stocks Cannot Provide a Dividend Payout

Microcap stocks are either once-successful companies listed on big exchanges that could not manage to stay there or new, struggling ones. With investment in penny stocks, you are less likely to see dividend payouts, considering their compromised position either way.

This minimises penny stock investment as a choice for income-oriented investors. Also, it does not allow dividend reinvestment, which is supposed to compensate for high-risk and low-growth investments.

This is one strong reason why penny stocks cannot be a good long-term investment. Individuals relying on dividend income or who may need the investment or a part of it in the near future cannot use penny stocks in the long haul.

Investment in penny stocks will rather be a time bomb because sooner or later, they may have to lower the stock prices to recover the investment. 

Payments

Pump and Dump Schemes and Biased Recommendations

Less transparency and high volatility make penny stocks a great investment plan for fraudsters. The low market cap makes the stock price vulnerable so that when a few investors buy huge numbers of a penny stock, the stock price pumps. This rise comes as an uptrend trajectory, and many investors enter the stock in hopes of massive capital appreciation.

Once many small investors do the same, and the market cap increases, the big whales sell their shares for higher prices and convert the small investors’ losses into huge profits.

The stock price dumps, and the small investors are left with two options: either wait for another pump or for the company to naturally grow into a mid-cap one or sell out at a loss and invest somewhere else. None of these is ideal.

Also, since there are no authorisations or authentic public files available for stocks listed on pink sheets or the Alternative Investment Market (AIM), individuals can be paid to recommend a certain stock. There will be no way to confirm and cross-check the opinion.

That’s why any information or direct recommendations about low-market cap stocks are never credible enough.

No money

Are Penny Stocks a Good Long-term Investment?

Penny stocks or micro-cap companies are not bound to fail, but they carry a high risk. You cannot really make a judgment on the basis of research, an analysis, or a track period, because there aren’t any. Investing in penny stocks may be a good idea for a little experiment or a side investment. But experts won’t recommend penny stocks as a good long-term investment.

If you are interested in other types of investments check out our article on the 4 types of investments.

4 types of Investments

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