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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

The 3 Questions All Penny-Stock Investors Should Ask Themselves

If you'd like us to answer one of your investing questions in our weekly Ask The Expert Q&A column, email us at editors@investinganswers.com. (Note: We will not respond to requests for stock picks.)

Question: Penny stocks seem like an inexpensive way to get in the stock market, but I’ve heard they are risky. What do I need to know about them? 

-- Kelly, Chicago, Illinois

The Investing Answer: "Penny stock" is absolutely one of the most confusing terms in the investment vernacular. 

Many people hear it and are scared off immediately. However, that doesn't mean that you should absolutely, positively  run from these stocks

You should, however, try to find out a little more about why they earned that label -- and ask yourself a few other questions as well.

1. What's The "Real" Purchase Price?

According to Quant Advisor CEO Richard Dude, generally, any stock trading at less than $1 is a penny stock. Although, sometimes the classification goes up to $5.

You can buy them at both in-person and online brokerages, Dude says, but you’re going to have to pay a trading fee. After all, the brokerage still has to make money

For instance, you buy 10 shares of a penny stock that costs 88 cents per share. That means your costs should be $8.80, right? 

Not quite. Say your trading fee is $9.95 -- on top of the $8.80 price of the shares. That means it costs more to purchase your stock than the stock costs. The total cost of the transaction is $17.75, pushing your new cost per share to nearly $2. 

This doesn’t mean you shouldn’t buy the stock, it just means you have to evaluate the stock based on the actual price tag.

This brings us to the second point...

2. What Made This Stock Into A Penny Stock?

There are different reasons for a penny stock being a penny stock: rough times, bankruptcy, being a startup are among the possibilities. You need to figure which category your stock falls in before you buy it.

Here’s how a penny stock purchase could workout in a best-case scenario.

I bought two stocks that hit rough times: GM and Ford. I bought them in even amounts because I figured one would survive if the other didn’t. I bought Ford for less than half the price of GM. I ended up coming out ahead because Ford prices soared and made up for GM going bankrupt. While I could have held onto the GM stock to see if anyone was paid out by the courts in bankruptcy, I decide to sell it beforehand.

I didn't feel comfortable trying to predict which stocks would result in payouts in bankruptcy. Getting 80 cents per share ($80) for 100 shares of a stock that I paid $5 per share for is a much better scenario for me than more than likely getting nothing.

While some stocks have seen bankruptcy payouts, this is not something the average person can predict, says Dude.

The final category for most penny stocks is a startup company trying to raise funds. For this category, it helps if you understand the industry. More than likely the company doesn’t have a proven sales track record yet. It could also be a small company on the verge of a huge medical discovery. You should find out as much information on the company as possible. Look through industry publications. Perform an online search.

3. Am I Willing To Take The Risk?

Investing in penny stocks is a huge gamble, Dude says. Be prepared for the stock to be a throwaway purchase.

“The last statistic I read on the matter stated that, on average, over 90% of penny stocks end up worthless,” says Mark La Spisa, certified financial planner. “So, yes, they are risky. Most who invest in them are speculators, not investors. The average American should stay away unless they truly understand they are taking a flier and can afford to lose their entire investment.”

Bottom line: These are risky investments and not portfolio-builders. But they can be a fun pastime if you want to invest a hundred bucks -- about the cost of a fancy dinner for two -- and see what happens.

P.S. -- It's tough to predict what any stock will do. However, our previous predictions have given investors 89%... 92%... 293%... and even 310% gains in a year. To hear our latest, including how Apple's next breakthrough could turn the banking industry on its head, click here.