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Key Terms Mentioned

Penny Stocks

When an equity is described as a penny stock, it usually means that the stock is low priced and trades over-the-counter (OTC), rather than being listed on a stock exchange such as the NYSE or the NASDAQ Stock Market.

Some OTC stocks are registered with the Securities and Exchange Commission (SEC), which means that there is plenty of information out there to help you make an informed investment decision. But you have to look for it on the SEC's EDGAR website, and it will be dense reading. Other penny stocks don't register with the SEC, so finding credible information about the stock is almost impossible.

What's more, very few (if any) market analysts follow penny stocks. While analysts' views may not always agree, whatever consensus there is may help guide you when you consider investing in a specific stock.

Resisting the Hype

If you get a phone call or an email from someone you don't know offering you the opportunity to buy a hot stock, it's probably a penny stock. It probably won't literally cost a penny. It might even be a few dollars per share.

As the old saying goes, forewarned is forearmed.

In many cases, these promotions are part of a scam. A typical scam is known as a pump-and-dump operation. With that, salespeople hawk cheap shares to drive up the price. The more buyers they can entice, the higher the price goes. Then the people behind the scam sell at the inflated price, which produces a substantial profit for them. But the momentum shifts from demand for shares to an oversupply, and the price plummets. Investors are left with worthless (or nearly worthless) shares.

Other scammers count on their ability to sell anything to anyone. When they've collected substantial cash from their unsuspecting victims, they close down the operation and move on to a new phone number or internet address. No shares are ever purchased and the investors' money is gone forever.

In the Interest of Fairness

Of course, some companies who issue very low-priced stocks turn out to be extremely successful. Investors who were willing to gamble may make out okay, but they typically end up with a miniscule amount of equity. In most cases, though, these start-up companies fail, even if their ideas are later the basis of a successful enterprise. Investors lose all their money.

It's also true that registering on a national stock exchange is expensive, so some legitimate companies prefer to trade OTC. There are a number of well-known companies based outside the United States that want to raise capital here and trade exclusively OTC. If there is plenty of information available to analyze these stocks with the same level of scrutiny you would give to an exchange-listed stock, you may still want to consider investing. But while they share the OTC listing, they are not necessarily penny stocks.

Overall, the key thing to remember is that you might not want to take more risk than you have to in order to accomplish your financial goals. In most cases, and for most people, penny stocks push the outer limits of reasonable risk. Often they go over the edge.