Penny Stocks and Gambling are the Same Thing. Here’s Why

Penny stocks avoid

Author: Tim Phillips

February 25, 2021

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There’s been another surge in GameStop Corp (NYSE: GME) shares this week. While the wallstreebets (WSB) crowd on Reddit are moving stocks again, it’s worth contemplating what’s actually “investing” and what is merely “speculation”.

As I’d written about GameStop previously, the extreme price rises were a potent mix of the masses battling shorts, options trading and unconstrained speculation.

However, beyond all that, GameStop was still a business. Clearly, it didn’t warrant a market capitalisation of over US$20 billion (which is what it reached at its peak in late January) but at least it had a recognisable brand.

The same can’t always be said of “penny stocks” – companies with a stock market listing and which have shares that typically trade for less than US$5 per share in the US (and perhaps in the tens of cents in Singapore).

Some have real businesses. Many don’t. Nearly all have short track records with limited disclosures on its actual business.

But why are people drawn to them and why should long-term investors avoid them at all costs?

History of scams

If anyone has ever watched “Wolf of Wall Street” with Leonardo DiCaprio, you may have been aware that the scams that his character (Jordan Belfort) ran for years were based on duping investors into putting their money into penny stocks.

It’s no surprise that penny stocks have a poor reputation – it’s one that they’ve earned over the years with numerous scandals.

Here in Singapore, the classic example remains the 2013 penny stock crash that wiped out S$8 billion from the local stock market and left many investors out of pocket.

Investigators found out that rocketing share prices were actually being manipulated by specific individuals. They were later charged and jailed.

Meanwhile, in the US, when the widely-known video-conferencing provider Zoom Video Communications Inc (NASDAQ: ZM) went public in 2019, shares of Zoom Technologies rocketed.

The problem? Zoom Technologies was the wrong company – with a ticker ZOOM that traded over-the-counter (where you can find many a penny stock on unregulated exchanges).

What’s more, Zoom Technologies was a penny stock that hadn’t recorded any sales since 2011. Yes, a listed company that had no sales for over eight years when it skyrocketed 6,900% in the lead-up to the real Zoom’s IPO, all because of mistaken identity.

Understand what’s gambling

Chasing penny stocks and putting money on them should be viewed as the same as going to the casino and putting money on black or red at the roulette table.

In effect, it’s gambling. For investors who are thinking about investing over the long term, these two takeaways are crucial.

First, establish the fact that penny stocks are pure speculation and, instead, put your money into real businesses. Second, don’t assume that just because a stock is under a certain price that means it’s good.

In fact, I find it tends to be the opposite. What matters at the end of the day is how much is (the total dollar amount) you’re investing.

Finding, investing in and holding great businesses for the long term will continue to be one of the best ways to compound your wealth over the long term.

 

Disclaimer: ProsperUs Head of Content Tim Phillips doesn’t own shares of any companies mentioned.

About the Author: Tim Phillips

Tim, based in Singapore but from Hong Kong, caught the investing bug as a teenager and is a passionate advocate of responsible long-term investing as a great way to build wealth. He has worked in various content roles at Schroders and the Motley Fool, with a focus on Asian stocks, but believes in buying great businesses – wherever they may be. In his spare time, Tim enjoys running after his two year-old son, playing football and practicing yoga.