I've recently gotten into several discussions on penny stocks, and I intuitively know that they're far more risky than large cap companies with real assets, but is there any measure of how risky they actually are, in terms of how often they go to zero?
Studies or well researched articles would be appreciated.
Penny stocks are only appealing to the brokers who sell the penny stocks and the companies selling "penny stock signals!". Generally penny stocks provide abysmal returns to the average investor (you or me). In "The Missing Risk Premium", Falkenstein does a quick overview on average returns to penny stock investors citing the following paper "Do Investors Overpay for Stocks with Lottery-Like Payoffs? An Examination of the Returns on OTC Stocks". Over the 2000 to 2009 time period, average investors lost nearly half their investment. A comparable investment in the S&P over this period would have been flat see here.
There is a good table in the book/paper showing that the average annual return for stocks priced at either a penny or ten cents range from -10 percent (for medium volume) to -30% to -40% for low or high volume.
A different paper, "Too Good to Ignore? A Primer on Listed Penny Stocks" that cites the one above finds that listed, as opposed to OTC "Pink Sheet" penny stocks", have better returns, but provide no premium for the additional risk and low liquidity.
The best advice here is that there is no "quick win" in penny stocks. These act more like lottery tickets and are not appropriate for the average investor. Stear clear!
Consider firstly that they're penny stocks for a reason - the company just isn't worth much. Yes, it could take off but this happenstance is rarer than you think.
Next, there is the problem of how you'd find out what the good stocks to invest in are. Here in the UK, reliable news about stocks outside the FTSE indexes (AIM) is hard to come by.
Also consider than there isn't the supply and demand for these stocks in the same way as there is in the main indexes. Even if you were to make a tidy profit over time, you might lose what you made in the delay selling the stock.
Start-ups also have the problem of poor cash reserves so new employees are often given stock options in lieu of cash which further depresses the share price.
I read a report once that said that only 1 in 10 penny shares yields a worthwhile return. I just don't like these odds so I tend to avoid.
The biggest problem with penny stocks is that they are easily manipulated, and they frequently are. Many of the companies trading as penny stocks have poor track histories of accurate financials, and what information that is available is not very reliable or verifiable.
I recall a few years ago when there were articles out there in financial circles talking about how more than a few penny stocks were being manipulated by organized crime syndicates.
Another big issue with penny stocks is liquidity. Since they're so thinly traded (not a great deal of daily volume), anyone who puts enough money into a penny stock to make it worth the effort almost certainly becomes the biggest trader in the stock, which can make it tough to liquidate positions. There are not enough market makers in the stock to be competitive, so you have to accept the bid/ask prices of whoever is willing to execute the trades, so the margins evaporate quickly.
Penny stocks are something you can trade if you're bored, have money to burn, and just want to toy around with something just for the heck of it that you'll ultimately lose out on.
Most penny stocks go to zero because most businesses fail.
You stated in your original post that you were wondering specifically about companies with no assets.
These are exactly the kind that fail and go to zero.
There are many holes within the regulatory structure that allow for many accounting tricks in penny stock land. And even in areas that are adequately regulated, there will be few to no remedies for the optimistic penny stock shareholder speculator.
Penny stocks are only appealing to two types of investors:
Most of the beginners who invest in penny stocks only do so because they don't have a lot of money to invest in the marketplace while starting out, or they would otherwise like to avoid investing their savings into penny stocks.
* If you are a beginning investor - do NOT invest in Penny Stocks *
Penny stocks are for the real gambler. Don't even think about holding them long. Buy a lot of shares and profit from a penny uptick. Rake a hundred dollars here and there a few times a week if you can. Don't fall in love with it. Trade for profit. Don't bet the farm. Only play what you can afford to lose at the Great Casino in the sky (the stock market). Sure, you will pick some losers, but you are not married to it, you don't have to keep it. A couple of good winners will erase some loses. Having lost thousands on the Blue Chips, and feeling I have wasted time waiting for an annual $100 gain on an ETF or mutual if I get lucky, has made me more risk tolerant for these "BAD" investments. The "GOOD" investments should do so well.
