5 Reasons to Avoid Penny Stocks at All Costs

John Divine

Listen, there's nothing wrong with saving a little scratch.

Ben Franklin's famous adage, "a penny saved is a penny earned," still rings true today, and if you can manage to invest those earnings -- well, you've just compounded a wise decision upon a wise decision.

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Of course, there are endless pitfalls one can make when investing. Ironically, one of the more dangerous traps investors fall prey to is the penny stock, an extremely inexpensive stock whose chief allure -- its low share price -- often tricks investors into thinking they're getting a great deal.

Reality is quite different: Investing one's hard-earned money in seemingly "dirt-cheap" penny stocks can, and often does, send an investor to the poor house.

Here are five reasons penny stocks are better left alone:

You can get in, but can you get out? Robert R. Johnson, president and CEO of the American College of Financial Services, touches on a few defining characteristics of penny stocks: Typically, he says, they're "small-market capitalization companies, with very high volatility, and poor liquidity."

But just because a stock has a small market cap and tends to be volatile doesn't mean the deck is stacked against the investor. Liquidity, however, is a bigger deal. "The lack of liquidity is what many penny stock investors find to be most frustrating," Johnson says. "Essentially, they often find that the market is extremely thin for penny stocks and that they must take a price reduction to find a willing buyer."

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Scam artists frequently use penny stocks for get-rich-quick schemes. Ever get an email talking about the next penny stock that will make you millions? Has the Prince of Nigeria recently asked for a short-term loan, promising 10 percent of his family's fortune in return?

David Twibell, president of the Englewood, Colorado-based Custom Portfolio Group, says penny stocks are chock-full of modern financial hucksters. "The penny stock market is heavily manipulated and exists primarily to separate unsuspecting investors from their hard-earned savings," he says.

"Scammers abound, and Internet message boards are rife with hot tips and recommendations designed to lure investors into thinking they've found the next Microsoft (ticker: MSFT)," Twibell says. "In reality, many of these companies are in financial trouble or have pie-in-the-sky business plans without any meaningful revenue or earnings."

There's a lack of transparency. The sort of opacity Twibell cites above simply isn't found in mainstream stocks. Developments in companies represented in the Dow Jones industrial average, for instance, are meticulously documented in prominent financial media outlets -- not mentioned by a guy named LuvStoxx55 in a nondescript online forum.

"Penny stocks generally trade in the wild, wild West of the over-the-counter market, which means that their reporting requirements tend to be minimal," said Charles Sizemore, a portfolio manager on Covestor and chief investment officer at Sizemore Capital Management, a registered investment advisor in Dallas. "It can be exceptionally hard to find reliable information about them."

Speculation versus investment. If you actually care about your returns, throwing money at penny stocks is a fool's errand.

"Penny stocks can actually be a lot of fun to trade," Sizemore says. "But that's just it. When you trade penny stocks, you should do so with your play money. Think of it as recreational trading and not the sort of investing you would do with your retirement nest egg."

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The allegation that that all penny stocks are worthless investments isn't always true. Every now and then, some obscure pink sheet player will rip off a face-melting rally and earn early investors some epic returns.

But don't be fooled. The odds are not in your favor.

You're betting against the house -- and the house always wins. Everyone remembers the grandma who won the $10 million jackpot playing the slot machine.

But no one recalls the 100,000 players who lost $100 apiece to pay her out. No news articles are written about the next 100,000 gamblers who flushed their hard-earned savings into the casino's bottom line.

"At the track there is usually a reason a horse is a long shot: it can't run fast," says Jeffery Born, professor of finance at the D'Amore-McKim School of Business at Northeastern University. "Penny stocks are the long shots of the investing world. For every one that pays off big, there are many, many more that don't."

Instead of betting on the underdog, investing in a diversified basket of well-capitalized, proven businesses -- members of the Standard & Poor's 500 index, for example -- improves your odds dramatically. You're no longer blindly playing the slot machines.

If you've managed to play the penny stock game and you've gotten out alive, count your lucky stars. Then run for the hills and never look back.

John Divine is an investor, freelance financial writer and assistant editor at InvestorPlace.com. Follow him (at your own risk) on Twitter @divinebizkid or spam him with email at jdivine@investormedia.com.