You've Been Warned: Investing In Penny Stocks Could Cost You

Penny stocks often catch the eye of many first-time investors looking to make serious gains with little cash. Listed on over-the-counter (OTC) exchanges, shares for these kinds of companies can be found trading for less than a dollar and can seem like a lucrative investment to strike it big. But beneath the low prices lie several risks that many new investors are not aware of. According to NerdWallet, these stocks can often belong to small startups or unproven companies with very limited financial transparency. The lack of information, combined with low trading volume and limited oversight, creates the perfect environment for manipulation and fraud.

While the appeal of turning a few hundred dollars into a small fortune is strong, the odds of doing so are slim. Before opening an account with an OTC exchange, it's important to understand the risks behind penny stocks and consider whether your money would be better off in a more stable and beginner-friendly investment opportunity.

One of the biggest dangers with penny stocks is the lack of reliable information. Unlike traditional assets where companies list their stock on major exchanges like the New York Stock Exchange or NASDAQ, penny stock issuers are not required to file regular financial statements with the Securities and Exchange Commission. This can make it difficult for investors to assess a company's performance and long-term potential. Additionally, the lack of transparency can result in bad actors falsifying financial records to entice potential investors.

Because penny stocks trade in low volumes, meaning that the number of stocks sold or bought is relatively low, small movements can create big price fluctuations. This creates the perfect environment for pump-and-dump schemes. Pump-and-dump schemes are an asset manipulation strategy where individuals, often backed by the company itself, create hype for a stock to artificially inflate the price. They then sell off their shares at the peak valuation and leave other investors holding a worthless stock. Without proper oversight and public accountability, penny stocks can be prime places for fraud and novice investors often end up losing money.

If you're looking to avoid penny stocks entirely, there are several different investment alternatives that are ideal for first-time investors. Paper trading can be a great way to get your feet wet in the world of stocks, exchange-traded funds (ETFs), and index funds. Paper trading is a simulated trading method where an investor can practice trading stocks with virtual money. Many popular fintech platforms offer paper trading features that mirror real-time market conditions, helping first-time investors build confidence before risking actual money.

Once you're ready to invest real money, you can consider investing in ETFs. These funds are diversified investment buckets that bundle multiple stocks into one and lower the risk tied to single stock investing. Trading ETFs can be ideal for beginners as they help sharpen their long-term strategy. For example, holding an S&P 500 ETF, which tracks the 500 largest companies in the United States, has historically returned around 10% annually. While penny stocks may promise quick gains, they come at extremely high risk. For first-time investors, paper trading and investing in ETFs can be a safer and smarter choice.