One of the most consistent mistakes a significant minority of inexperienced investors make is being drawn to a type of common stock known as penny stocks. At first glance, the reasons for this ultimately dangerous appeal are legion but almost always come down to the fact that penny stocks appear to fluctuate tremendously in price, which, they convince themselves, should lead to an opportunity to generate a very high return quickly.

Unfortunately, as with all things in life, the truth is not quite so simple. In fact, it often turns out to be precisely the opposite as penny stocks can wipe out your savings in the blink of an eye.

How is this possible? This overview was written to help you understand some of the biggest risks. At the very least you should walk away with an understanding that buying these securities has more in common with playing slot machines in Las Vegas than a disciplined investment program.

They almost always trade on the pink sheets or over-the-counter markets because no respectable stock exchange will permit them to be listed. Under rare circumstances, former blue chip giants can fall from their lofty heights, becoming penny stocks.

Use Caution Trading Pink Sheet Stocks | Investopedia

The last time this happened on a widespread scale was during the Great Recession of when many financial institutions and investment banks went broke after being over-leveraged. Those that didn't go bankrupt but still wanted to retain some semblance of respectability were forced to undergo reverse stock splits to keep their share prices above the penny stock thresholds. The reason most people seem to be drawn to investing in penny stocks is because these companies fluctuate wildly in very short periods of time.

Unlike giant blue chip stocks which enjoy deep liquidity, some of these companies might not have any buyers or sellers for days at a time.

You could put in a sell order and it would just sit there, day after day, doing nothing. To illustrate this point, I randomly picked a penny stock to use as a real-world example.

Penny Shares

For the sake of protecting the ignorant, I'm redacting the name and ticker symbol of this particular firm. Here is the relevant data:. The opposite is true if you were a seller. On top of this, if you purposely attempted to influence the share price by placing orders in an abusive way, you are very quickly going to be caught by the Securities and Exchange Commission, face large fines that more than offset any potential gains you might eke out of the process, and, if you committed some particularly egregious sin, possibly even go to jail or be banned from working in the securities industry for the rest of your life!

The reality of the situation is that there is no intelligent reason an investor needs to trade penny stocks or hold them in any type of portfolio.

The risks are simply too great to offset any perceived benefits. While it may seem boring, a diversified, low cost index fund is a superior choice for many new investors. The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors.

13 reasons why penny stocks are risky: What to know before investing

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Updated January 31, There Is Simply No Need To Trade Penny Stocks The reality of the situation is that there is no intelligent reason an investor needs to trade penny stocks or hold them in any type of portfolio. Get Daily Money Tips to Your Inbox Email Address Sign Up.

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