“Do you invest in stocks? You can make a ton of money trading Penny Stocks!” I’m sure you’ve had at least one person tell you something like this before. They have this fantastic way to make a ton of money! It is true that some people have made a considerable amount of money trading Penny Stocks, flipping houses, and just straight up gambling. But is it a good investment? Turns out it’s usually just dumb luck or a scam.
When people ask me if I invest, I like to start off with a simple “yea, I invest” and see where they steer the conversation from there. (omitting the fact that I’m so obsessed with personal finance that I created a whole darn website to write about it!)
As soon as they lead off the conversation with a Get Rich Quick mentality, I am immediately skeptical and take everything they say with a grain of salt. It is not like they are out to scam you; usually they actually believe what they are about to say is a good idea–just because they believe it doesn’t mean it’s true!
People Only See The Winners
One of the reasons people become so enamored with these Get Rich Quick ‘investments’ is the news stories showing people turning $1,500 into $1,000,000 in just a couple of years by trading Penny Stocks. No one tells the stories about the people who have lost ridiculous sums of money trading Penny Stocks–that’s not sexy or exciting and no one would read it. People want to hear about this guy who day trades Penny Stocks and got rich quick!
Side-note: Penny Stocks are stocks of small companies who do not meet the requirements to
be listed on the New York Stock Exchange. They get their name from usually having stock prices under $1 per share.
Day trading stocks is a zero sum game–meaning for you to make money someone else must lose it and vis versa. Someone’s gotta lose. Don’t let it be you.
If you only hold the stock a few hours, any returns are completely speculative.
If everyone invests for the long-term and holds stocks for many years, then it turns into a positive-sum game–meaning everyone can make money. This investment return is driven by growth in the company’s earnings or earnings potential (and inflation…).
With day trading Penny Stocks, there is no such investment growth potential–the time frame is simply too short.
So if everyone day trading Penny Stocks is basing their decisions on speculation, you can argue that they are just flipping coins.
When you have an entire system of coin flippers, by completely dumb luck, some are going to get it right every time! And people call them winners or ‘genius’! These are the people we read about who turned $1,000 into $1,000,000! They are not brilliant day traders, it is just simply mathematical probability. And remember that someone had to lose money for the winners to make money.
Probably not a great idea to invest based on these few lucky we read about when many more Penny Stock Investors aren’t so lucky.
Big Fish Stories
100% guaranteed, if you’re in a group at a party, people will be telling stories of the enormous, record breaking fish they caught–not the days they sat in a boat all day and didn’t catch a single fish. They are going to tell the victory tales, not so much the defeats.
It’s the same way in the investing (and gambling) world. People love to talk about their crazy, amazing, absolutely b-a-n-a-n-a-s returns! But no one likes talking about the times they lost their entire investment in a bad stock pick.
It’s just human nature. We want to look good in our social setting–some leftover subconscious behavior for our early days in humanity.
Pump and Dump Schemes
Imagine if you could play a coin toss game, but you could influence the results. If you could make a coin that lands heads 60% of the time, you could rig the game and win more than others. Some people try to rig the Penny Stock Game.
In addition to the coin-flipping nature of Penny Stocks, some have sought to take advantage of other investors with scams that prey on the uninformed coin-flippers looking for a ‘hot-tip’.
Pump and Dump, they call it.
It only works because there is not a lot of trading volume in Penny Stocks–when someone makes a big trade it can have a pretty large effect on the stock price.
Then the scammers go and buy up a lot of the available stock, sending the price higher.
Their hope is that others will see the price increasing, believe the stories on the message boards, and buy even more stock–sending the price even higher.
Now the scammers sell all off their stock while the price is higher. They make their profit in a matter of hours or even minutes. The stock price comes crashing down soon after the scammers sell.
Pump the price up. Dump and the price goes down.
Remember, day trading is a zero sum game and these scammers are after your money!
FOR THE LOVE OF GOD USE LIMIT ORDERS!
Since Penny Stocks are thinly traded, you can get burned as soon as you buy if you’re not careful.
Always use Limit Orders, NEVER USE MARKET ORDERS FOR PENNY STOCKS. DON’T DO IT!
If the stock price is $1, that doesn’t mean people will sell it for $1. They might ask for $1.02, $1.2, or even $2! They set up automatic sell orders at $2 even though the stock price is $1. If he is the only one selling at the time and you use a market order, you will end up paying $2 for a $1 stock! Ouch!
A market order simply buys a stock at the next available price. With Penny Stocks, the next available price could be ludicrous!
Don’t Play A Losing Game
Some Financial Advisors will allocate a small portion of a portfolio to speculation (5%-10%). I don’t know how many would actually recommend Penny Stocks–I’m guessing not too many. No adviser would recommend day trading to Get Rich Quick.
I really don’t like day trading stocks. Day trading Penny Stocks is even worse. Maybe you can find some value in a few Penny Stocks by buying a good company and holding on. Be ready for a crazy ride because most of the people trading these stocks are coin-flippers and moves in the stock price don’t necessarily mean anything about the actual company.
I would rather play in the positive-sum game where you get real investment returns in the form of growing earnings and dividends. This way I am not even giving scammers or day traders the chance to take my money–they can’t take what I’m not selling! Investing can be simple and stress-free. For most participants, Get Rich Quick schemes are pretty much always doomed from the start.