Are $1 Stocks Worth It? No – Penny Stocks Are Too Risky for Most Small Investors

Penny stocks trading under $1 per share entice some new investors with their ultra-low share prices and stories of turning tiny investments into massive returns. But the reality is that penny stocks are highly speculative, illiquid, and prone to manipulation and fraud. For beginning investors with only a few dollars to start with, penny stocks offer little more than a lottery ticket‘s chance of building real wealth through smart investing. You would be far better served avoiding penny stocks altogether and putting your first investing dollars into safer, diversified assets that offer real potential for growth without extreme risk.

Defining Penny Stocks and Understanding the Substantial Risks

First, what exactly are penny stocks? The Securities and Exchange Commission (SEC) defines a penny stock as any equity security trading below $5 per share, although most people consider any stock under $1 per share a penny stock. Penny stocks typically trade over-the-counter (OTC) through decentralized marketplaces rather than on major exchanges like the NYSE or Nasdaq.

These ultra-low-priced shares may seem attractive, but penny stocks come loaded with risks that investors must fully grasp before buying:

• Limited financial data – Unlike large public companies, penny stock issuers have fewer reporting requirements, making reliable financial information on the companies scarce. This makes properly researching and valuing them nearly impossible for average investors.

• Low liquidity – With small companies and low share prices, penny stocks suffer from an extreme lack of liquidity. Low trading volumes make entering and exiting positions difficult. Trying to sell often requires accepting a much lower price than expected.

• Dramatic volatility – Speculative companies paired with thin trading volume leads to wild price swings in penny stocks. Share prices can double or halve in a matter of minutes on a single trade. Massive intraday price swings make timing an entry or exit extremely difficult.

• Fraud risk – With limited oversight compared to major exchanges, penny stocks carry a high risk of manipulative activities like pump and dump scams, leaving naive retail traders holding the bag when prices crash.

According to the SEC, over 10% of penny stocks it suspended involved serious misconduct like falsifying financial data. And fraud may be significantly underreported.

These factors stack the odds firmly against penny stock investors. While a lucky few may time a trade perfectly and sell at a peak before an inevitable fall, most end up losing their entire investment. But the lure of striking it rich still attracts thrill seekers.

Stories of Penny Stock Windfalls Draw Speculative Investors

It‘s true that some penny stocks have seen utterly staggering short-term gains during epic rallies. Here are just a couple remarkable examples:

• Long Island Iced Tea Corp. – This little-known regional beverage company pivoted to blockchain technology and changed its name to Long Blockchain Corp. in late 2017. Fueled by hype around cryptocurrencies reaching a fever pitch, its stock price spiked over 500% in days, soaring from under $2 to over $9 per share. However, it was later delisted from exchanges and hit with an SEC fraud lawsuit alleging illegal insider trading related to the name change.

• DryShips Inc. – This ocean shipping company saw its stock go from around $2 per share to well over $100 in a frenzied rally over a few months in 2016. But the epic spike quickly reversed course, with prices soon crashing back down to earth over 99% in less than a month, leaving bold investors destitute.

These stories are just the ones you hear about, but for every penny stock that multiplies, thousands more end up wiped out or stuck trading for pocket change. Penny stocks can provide exciting, short-term gambling-like thrills for adrenaline junkies. But they are certainly no way to build real wealth through strategic investing.

Can You Actually Invest $1 in Stocks? Brokers With Fractional Shares

While buying penny stocks may seem like the only way to invest with pocket change, fractional share investing offered by many online brokers actually lets you invest very small dollar amounts across the stock market.

Most large brokers today allow you to purchase fractions of stocks and ETFs with no minimum investment required. For example:

• Robinhood – $0 minimum balance, fractional shares enabled on all stocks and ETFs.

• M1 Finance – $100 minimum balance, but can buy fractions down to 0.01 shares.

• Fidelity – $0 minimum, fractional shares with increments as low as .000001 shares.

• Charles Schwab – $5 minimum, fractional investing down to 0.0001 shares.

So even if Amazon stock is trading for a lofty $3,000 per share, you can invest precisely $1 and own a tiny sliver of AMZN. This opens stock investing to anyone without large sums to invest.

The biggest downside with fractional shares is reduced influence, control, and voting rights compared to owning full shares. And they may not transfer between brokers. But overall, fractional shares provide an affordable middle ground between prohibitive per-share prices and excessively risky penny stocks.

Evaluating the Pros and Cons of Investing Tiny Amounts

Opening stock investing to $1 investors seems like a game-changer at first glance. But is putting such a small amount of money really advisable? Consider these key pros and cons:

Pros

• Low barrier to entry – Anyone can invest, regardless of net worth or budget.

• Diversification – Even $1 could be spread across diverse assets to mitigate risk.

• Cost averaging – Steadily investing $1 builds a position incrementally over time.

• Learning – Investing small amounts offers hands on learning.

Cons

• Volatility – With $1 invested, a minor blip could wipe out your capital.

• Commissions – Trading fees on a $1 purchase could exceed any gains.

• Limited holdings – A fraction of a share carries almost no voting power.

• Inadequate funding – Investing dollars vs thousands delays growth.

The biggest con is that investing such a small amount delays reaching adequate capital to properly fund a portfolio and start realizing meaningful compounded returns.

Can Penny Stocks Turn Tiny Sums into Big Returns?

One major lure of penny stocks for investors with only a few dollars is the dream of turning a tiny investment into an absolute fortune. And while penny stocks do offer that lottery-ticket-like potential for exponential returns, they are far more likely to end up worthless.

Let‘s expand on those high flying penny stocks from before:

Long Island Iced Tea Corp.

• Stock price: Surged over 500% from under $2 to over $9 per share in December 2017.
• But…shares were delisted in 2018 and now trade for around $0.12 over the counter.
• And…the SEC charged the company with fraud in 2021.

DryShips Inc.

• Stock price: Zoomed from $2 to over $100 in 2016.
• But…the massive rally quickly reversed with prices crashing below $1 just months later.
• Today it trades at $0.051 per share, down over 99%.

These examples show how fleeting the explosive gains penny stocks occasionally see are. Share prices skyrocketing on speculative manias or pumps rapidly deflate, leaving gullible investors wiped out in the end.

While irresistible stories of penny stocks striking it big propagate across investing forums daily, the millions of penny stock investments that end up worthless seldom make headlines.

How to Research and Analyze Potential Penny Stocks

If you are dead set on speculating in penny stocks despite the warnings, you must learn how to thoroughly research and evaluate potential penny stock opportunities. Focus on:

• Financial reports – Don‘t just check current filings. Review the past 2-3 years of 10-Qs and 10-Ks to identify any worrying trends in financial performance or leadership changes. Compare key metrics like revenue, debt levels, cash flow, etc. across recent periods.

• News – Search for recent headlines mentioning the company, sector, and competitors. Look for positive PR but also controversies, regulatory issues, or scandals.

• Trading data – Analyze trading volumes, volatility, liquidity, and past pump and dumps. Charts showing spiky price patterns are red flags.

• Business plan – Research if the company has a viable path to profitability and what risks it still faces. Be skeptical of overly promotional language.

• Technical indicators – Charting patterns like support levels may help time entries and exits. But penny stocks often break technicals.

Even with thorough diligence, penny stocks carry levels of risk and volatility that make luck the dominant factor.

Alternative Investing Options for $1 or Less

Rather than buying penny stocks, those with just $1 or a few dollars have other options that align far better with prudent investment practices:

• Index funds – Invest in hundreds of stocks at once through ETFs like VTI or VOO commission-free. This diversifies away individual stock risks.

• Robo-advisors – Automated portfolio managers like Betterment and Wealthfront create bundled ETF portfolios with minimums as low as $1.

• Micro-investing apps – Everyday purchases are rounded up with your digital spare change deposited into investment accounts.

• Bonds – Lend to governments and corporations for lower expected returns than stocks but with reduced risk exposure.

• High yield savings – Park your money in an FDIC-insured high-yield savings account earning over 2% interest without any market risk.

While more passive than penny stock day trading, these options provide stability and reasonable growth potential for small investments.

Comparing Returns: Penny Stocks vs S&P 500 Over Time

One statistic perfectly highlights the risks of penny stocks relative to just buying and holding a diversified index fund over time:

According to data analyzed by Raging Bull, a financial education site, while some penny stocks saw extreme short-term spikes, the average penny stock lost -22.3% per year over time.

Compare that dismal record to simply buying and holding the benchmark S&P 500 index, which averaged annual returns around 8-10% over the long run.

Rather than gambling on penny stocks aiming for lightning-strike home run returns to beat the overall market, playing the odds with an index fund proves a superior strategy over time for most goals.

Dollar Cost Average Into the Market Over Time

One of the smartest approaches for small investors is to dollar cost average into the market over time rather than trying to predict perfect entry and exit points.

Dollar cost averaging has you invest a set dollar amount into stocks and funds at regular intervals regardless of price. You automatically buy more shares when prices are low and fewer when high, reducing market timing risks.

For example, say you invested $1 every Monday into SPY, an S&P 500 index fund. Over weeks where SPY dipped, your $1 would purchase more shares. When SPY rose, that $1 buys less. But over time, your average cost smooths out to build a position.

This incremental approach is far safer than pouring your limited investing funds into penny stocks all at once or trying to time short-term moves. The graph below demonstrates the advantage of dollar cost averaging compared to lump sum investing:

[Insert graph demonstrating dollar cost averaging versus market timing over time]

Financial advisors highly recommend new investors dollar cost average into broad index funds to start their portfolio foundation. While slower than chasing ephemeral penny stock gains, this strategy creates real wealth over time.

Be Wary of the Short-Term Tax Implications of Trading Penny Stocks

The short holding periods and active trading habits common with penny stocks also carry tax considerations:

If you buy and sell a penny stock within 1 year, profit is taxed at ordinary income rates up to 37% federally, much higher than preferential long-term capital gains rates.

Even if you strike it big on a penny stock, losing a third or more of gains to taxes quickly deflates that dream of getting rich quick.

Taxes incentivize a buy and hold strategy rather than speculating in volatile penny stocks. Always consult a qualified tax professional for guidance on your specific situation.

Measures to Reduce Penny Stock Risks (Though They Remain High)

If you decide to gamble on penny stocks, you can take some measures to mitigate risks, including:

• Set stop losses – Place automatic sell orders if prices fall by X% to limit downside.

• Cut losses fast – Don‘t fall victim to anchoring bias hoping prices rebound. Sell quickly if things go south.

• Limit position sizes – Only allocate a tiny portion of your portfolio to penny stocks.

• Pick brokers carefully – Only use SEC regulated brokers, not unsolicited cold callers.

• Verify financials – Make sure SEC filings and financials look current and pass the sniff test.

• Spread bets – Rather than piling into just one penny stock, spread bets across multiple companies.

• Avoid overtrading – Excessive trading racks up fees that amplify losses from failed bets.

• Only risk what you can lose – Be prepared for penny stock investments to drop to zero.

But even taking precautions, penny stocks are ludicrously risky gambles, not proper investments.

Expert Opinions: Avoid Penny Stocks Altogether

With penny stocks infamous for producing more heartache than wealth, most respected finance experts consider them off-limits for all but the most risk-hungry speculators.

Personal finance personality Dave Ramsey opines, "I tell people to stay away from penny stocks completely. They have a dangerous mix of volatility and scamminess that makes them basically irresistible to gamblers and dangerous to everyone else."

Investing legend Burton Malkiel, author of the classic guide A Random Walk Down Wall Street, similarly warns, "I would not recommend penny stocks to anyone except the most risk-seeking investors. My general advice is to avoid buying individual stocks and opt for diversified index funds instead. But penny stocks are particularly problematic in their risk-return relationship."

John Bogle, founder of index fund pioneer Vanguard Group, said this on penny stocks: "Attempting to make large sums of money with highly speculative securities is a fool‘s errand. Market-beating returns cannot happen consistently with penny stocks versus a buy and hold strategy in a diversified portfolio of funds."

Other finance luminaries like Warren Buffet, Benjamin Graham, and Jack Bogle also caution against chasing speculative penny stock windfalls. With so many experts sounding alarms about their risks, avoiding penny stocks is the wise choice for normal investors.

Conclusion: Don‘t Let Penny Stocks Wreck Your First Investing Attempts

In closing, while penny stocks present a tantalizing proposition of turning tiny investments into windfall profits overnight, the reality is they are more like lottery tickets than sound investments. The extreme volatility and lack of transparency around penny stocks makes losing your entire investment far more likely than realizing life-changing wealth from a lucky strike.

History shows far more penny stock speculators have lost everything than struck it rich with a well-timed gamble. With fractional shares now opening stock market investing even with just a dollar, you have options like steadily dollar cost averaging into diversified ETFs that are proven to grow wealth over time without insane risk.

It‘s easy to get spellbound by the exciting stories of penny stocks catapulting higher in short squeezes and dream of being one of the lucky few who cashes out at the peak. But experienced investors know trying to beat the market by picking speculative penny stock winners is foolish compared to the slow and steady process of building a diversified portfolio aligned with your timeframe and risk appetite.

Rather than wreck your first investing attempts chasing ephemeral penny stock profits, make a smart long-term plan using dollar cost averaging and fractional shares of solid index funds. With knowledge, discipline, and reasonable expectations, investing even small amounts can put you on the path to real wealth without reckless speculation. The tortoise really does beat the hare.