Why Do Penny Stocks Get a Bad Name?

by JT McGee

I wanted to provide some perspective on why penny stocks get a bad name.

You see, most people will not invest in penny stocks because they are inherently bad – something to avoid at all costs.

But why do people think this way? Why does a penny stock automatically attract negative opinions?

It’s all about history!

If someone says something over and over again, it soon becomes fact. Generally accepted “facts” are often wrong. How often have you seen someone hurriedly throw a beer into a freezer because “alcohol doesn’t freeze?” Pure alcohol does freeze, just not at temperatures your freezer can reach. Beer, being mostly water, will absolutely freeze in a freezer. Hard liquor, being 40%+ alcohol, will not freeze in a common kitchen freezer.

See? A good general rule of thumb becomes a principle that is incorrectly used to justify decisions which one believes are ingrained in rational thinking.

If you understand stock market history, you’ll understand why penny stocks are untouchable for investors.

Here’s why penny stocks used to be uninvestable:

  1. Fractional quotations – Before computers took over Wall Street, quotes were delivered in fractions. At one point, the smallest fraction was 1/8th of $1, or 12.5 cents. This was later reduced to 1/16th of $1, or 6.25 cents. This obviously affected penny stocks more than higher priced securities. If you pay a spread of 6.25 cents to buy a $.50 stock, you’re down 12.5% just due to the spread. The same 1/16th of $1 spread on a $100 stock is a much more digestable loss of .00625%.
  2. Trading costs – Commissions are now priced on a flat-rate system whereby investors pay something like $5-10 to place a stock trade of up to 10,000 shares. In days gone by, investors would pay a “mark up” to buy or sell stock. That meant you might pay $.10 per share instead of a simple flat trading commission. Obviously a mark up of $.10 per share on a $1 stock is way worse than a markup of $.10 per share on a $100 stock.

For decades…actually, probably a century, penny stocks were not economical to own. Investors would have to tolerate a huge per-share mark up on top of a bid-ask spread. Thus, investors could lose 25% or even more of their capital by simply buying a penny stock. If at any point you overpay by 25% to buy an investment, you’re probably not going to get a good return.

So, naturally, it was advisable to avoid penny stocks. Because humans naturally like the most simple answer for anything, an explanation on the effects of trading costs eventually boiled down to “don’t buy penny stocks.”

Penny stocks in modern markets

It is only marginally more costly to buy penny stocks today than it is to acquire high-priced securities. Most retail brokers charge a flat fee per trade for up to 10,000 shares of a stock. Also, spreads have all but been eliminated by a limit order. So long as you intend to purchase fewer than 10,000 shares of a penny stock, it is no more costly than a similar dollar investment in a company that has a higher per-share price.

However, old ways of thinking are hard to rattle. The logical case for avoiding penny stocks no longer exists (costs are the same), but the viewpoints that developed in response to that logical thesis still exist. It took decades for investors to digest the logical reasons for avoiding penny stocks. It will likely take many more decades for investors to see that penny stocks are equal to costlier stocks – and it will only happen if this idea is spread.

Frankly, everyone is free to have their own prejudices toward investments. However, I do think everyone has a responsibility to be educated in the logic behind their prejudices.

All else being equal, there is no difference between Walmart shares at $1 per share or $60 per share, so long as investors wish to acquire less than 10,000 shares at one time. The additional cost of acquiring penny stock shares is so marginal that it is not worthy of discussion, so it is not discussed.

However, the viewpoints that emerged from those costs remains long after the argument wore out its welcome. And I have a feeling that penny stocks will never been seen as equals ever again.

{ 3 comments… read them below or add one }

Value Indexer March 24, 2013 at 21:41

I think it’s mainly guilt by association at this point. In the past it was difficult to trade those stocks, now it’s somewhat less so (a stock priced at $0.10 still can’t move by less than 10%). But if a company doesn’t do a reverse stock split to get to a higher share price what does that say about them and the type of investors they are attracting?

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PK March 26, 2013 at 10:29

I think there are still a few brokers who jack up the price on stocks under $5 (or $1, depending… since that’s actually a penny stock).

But yeah, no excuse – and, you don’t mention it here, but you won’t have institutions sniffing around, since they might accidentally buy the whole thing. Definitely under-looked.

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William @ Bite the Bullet April 1, 2013 at 11:34

Stock market investing, whether we like it or not, involves a healthy dose of psychology. This manifests in several ways:

1. Liquidity: When I want to sell, I need to know there are many buyers out there.
2. Credibility: Big companies are highly visible and many others follow them. When they do well, it’s well known. If they screw up, the same. Small companies, like it or not, toil in obscurity.
3. The Operators: Scam artists have a hard time making a living on stocks like 3M, Google and IBM. However, they seem to flourish in the penny stock market.

If a small company is good, it will grow out of the penny stock market. The USA is big enough that even at that point, there’s enough growth potential that even if we get into the stock after it emerges from the penny stock market, we can still make good money.

Personal history: I thought I found three good small (penny) stocks and dipped my toes into the water with them. All three toes got bitten off. You know the definition of insanity… :)

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