Penny Stock Risks

There is a term that seasoned investors use to describe what happens to new investors who lose money due to inexperience, they call it 'paying tuition'. Everybody has to pay for an education, there is no getting around it, the stock markets are the same, you will pay a price to learn your lessons. All you can do is hope to minimize the cost of your education which can be done by watching out for the following:

The pump and dump

This happens with all kinds of stocks, even large ones like Intel or Google. When you see Wall Street giants like Merrill Lynch and Goldman Sachs banging their drums telling you how great Google is at $400, only to see it drop to $330 a few weeks later, that is a pump and dump on a big scale. Merrill and Goldman want to get their clients out at the best possible price, they will get analysts to put out glowing report, go on CNBC and hold conferences to do this.

The same is true of penny stocks, except things happen much faster but on a much smaller scale. You will often see the following pattern on message boards:

John45: CHECK IT OUT! XYZW MULTIBAGGER! ITS GOING TO EXPLODE!!!
Jane2938: WOW! You are right! This looks great!
Tammy28c0: Nice find! Im in for 100,000 shares!
Daisy047: Me too! Im buying 10,000 shares tomorrow!

(Also see video: Anatomy of a penny stock pump and dump)

Sounds like XYZW might be a good stock right? We do not know, this may or may not be a good buy, but the one thing that is for sure is that John and all those other investors have most likely already taken a position in that stock and will be looking to sell it if it goes up. If enough people get interested from these kind of messages, the stock might actually go up, but once John and Jane start selling (and they own a lot of shares), the stock will start dropping. Make sure the stock you intend to buy has enough volume and liquidity for you to get in and out of without causing a big change in price.

Deflection Techniques in Press Releases

If you read a press release by a company, try reading past the obvious. Watch out for the tricky numbers and statistics. If company WDGT makes widgets and sells $4000 worth of product every month, which is declining month over month due to a better widget being made by a competitor, watch out for things like: "The widget market is $4.5B market in North America and is growing by 15% every year. WDGT is hoping to penetrate this market and expand into Asia which is a $2.8B market."

Those are impressive numbers, but they do little to change the bottom line. Be watchful for deflection techniques.

Tips from one page websites or spam email

Companies need to pay for exposure, Intel, Apple, The Gap, they all advertise with million dollar budgets so people will buy their goods or services and in turn generate revenue which drives the stock price. Penny stocks are small companies that do not have million dollar budgets to attract attention, so what they do is hire investor relations and promoters to drum up interest in the company.

There are good and bad promoters, the spam you get in your email box telling how WDGT is a $0.03 stock today but will go to $4 in 1yr, that is bad promotion. Websites with factual information, giving you all the contact details for the company and other relevant information so you can make your own decisions are the good ones. Again, use common sense, you should always double check the facts with an official from the company before you make a decision. When you buy stock in a company, you are an owner of that company. Their investor relations team now works for you. Use this fact to get all the information you deem necessary to make an informed decision.

Return to main page.