Two of the biggest motivating factors in the world are the emotions of fear and greed. Fear can keep investors from investing at all or cloud their judgment and cause them to panic and sell a stock at the wrong time.
Greed, on the other hand, causes investors to take undue risks. They margin their stocks heavily or they chase lofty stocks that are already trading at insane valuations because it seems that "everyone" is in the stock and they don't want to get left behind.
But then there's another common mistake that investors make that is due to greed. It's investing in penny stocks. These are stocks that are generally priced under $1 per share.
Penny stocks initially seem so enticing. You can get a gazillion shares even with a small amount of money. So you feel like you own a lot of it. Secondly, a small move higher is a huge percentage move upward and can cause a huge gain, profit-wise.
So what's the problem with that? There are a few major reasons why penny stocks rarely pan out and produce the great gains that people tout.
For starters, penny stocks have wide spreads and tend to have low volume. The spread is the difference between the price at which you can buy the stock and the price at which you can sell the stock. The buy price is always much higher than the sell price is. So even with a large gain, much of the gain consists of just getting the selling price of the stock up to the buy price level or better. And this doesn't even factor in your commission costs.
So the selling price of the stock has to climb a long ways to get above the buy price and high enough to overcome the commission costs too in order to become profitable.
With the typical stock out there, these spread costs are fairly low and the price doesn't have to move much to put the sell price greater than your buy price is. But that's not generally the case with penny stocks.
Additionally, these tend to be lower-volume stocks. So your fills can be slow and at various price points that are unfavorable to you.
The low-volume nature of penny stocks also makes penny stocks a favorite of scammers who love to "pump and dump" the stock. By that, I mean that they get up a huge following through email lists or some other communication venue (Twitter, etc.). They buy the stock, then tell their ton of followers to do the same. These other investors end up pushing up the stock price for the scammer and the scammer gets out with a nice profit while your price generally never made it up high enough to produce a nice profit. In other words, they used you for a profit. They "pumped up the stock" and then "dumped" it.
A penny stock is more easily controlled due to its low trading volume. You see, if someone buys 10,000 shares of a 50 cent stock that trades 20,000 shares in a day, they're going to move that stock price considerably and be able to manipulate the price for their advantage.
Had they been in a stock that trades millions of shares a day at a higher price point, they'd not likely be able to do this. So that's why the scammers love penny stocks. And that's one reason why you should not love them. You're typically on the late end of the trade they tell you about.
The next great reason to stay away from penny stocks is because most large institutions are barred from investing in stocks under $5 per share and some are even stricter and won't allow investing in a stock under $10 per share.
The problem is that all of the "big money" can't get into the stock and, therefore, a larger sustainable push higher in the stock is not likely to happen with the "big boys" being out of the game.
In other words, imagine telling most every mutual fund, pension fund, etc. out there that they can't invest in a stock. That's what you have when you have penny stock investing. There isn't the proper volume in a penny stock for these funds to invest. Yet it's these huge funds investing over time that is needed to cause a real, sustainable rise in a stock. That element is totally absent in penny stock investing. Yet it's totally present in stocks above $5 to $10 per share.
A prime example of this is a stock that I invested in some months back. Then a month or so ago, a billionaire investor invested $1.5 billion into the stock. Well, what did it do? It pushed my shares up quite a bit upon this huge investor investing and upon others hearing that he invested and they invested as a result. So the huge volume of buying that came propelled the shares that I owned much higher. This is what you want to have happen. You want large institutions to have the ability to invest their money in stocks that you are in. The penny stock investor doesn't have that luxury.
So I hope what you get out of this is that the penny stock investor has a ton of things going against them that the typical stock investor doesn't have going against them. I hope you see penny stocks aren't as glorious and as much "easy money" as people make them out to be.
Therefore, the next time your buddy tries to get you to buy a penny stock or you get an email that is pushing a penny stock, I hope you'll remember what I'm teaching you today and you'll avoid a huge pitfall.
About the Author: Sean Hyman
Sean Hyman is a member of the Moneynews Financial Brain Trust. Click Here to read more of his articles. He is also the editor of Ultimate Wealth Report. Discover more by Clicking Here Now.
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