The Danger Of Penny Shares

Ever wonder what penny shares are, and whether they really cost a few cents? Read on. The term 'penny share' …

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Ever wonder what penny shares are, and whether they really cost a few cents? Read on.

The term 'penny share' comes from the USA, where their one cent coin is called a penny (believe it or not, the one cent coin is still in circulation in the US, even though it costs 1.62 cents to actually produce the coin – no wonder they have a massive budget deficit).

In the days of yore, penny shares often did cost only a cent per share. Today, any share selling for less than around 20 cents or so per share might be considered a penny share. They often represent companies with less-than-stellar track records that nonetheless promise great success around the corner. (Revolutionary gold-deposit detectors! A cure for the common cold! Billions of tonnes of uranium!)

Penny shares can be dangerous, because people think low prices mean bargains, and assume that they'd be better off spending their $500 on 6000 shares of a penny share than on 20 shares of, say, Westpac (ASX: WBC).

Believe it or not, a share might be grossly overvalued at 8 cents per share, but significantly undervalued at $20 per share. Many people don't understand this, and they often gravitate toward the 8 cent share, thinking it'll more quickly double in value.

That's a risky assumption, though. Your performance when holding a share really depends on the company's intrinsic value, not its trading price; the price at which you buy into the share; and the amount of money you invest, not the number of shares you own.

Surely thousands of shares are better than one? Almost certainly not.

Imagine that you buy 1000 shares of a $0.06 share and one share of a $60 share. You'd spend $60 for each investment. (This is an example, with commission costs disregarded.)

If each investment doubles in value, you'll have 1000 shares of a $0.12 share, worth $120, and one share of a $120 share, worth $120. You would have gained no advantage by buying the lower-priced share. There is just as much chance, perhaps even more of a chance, of a $60 or $10 or $40 share doubling in value, and holding its value for the long-term, than a typical penny share.

Most penny shares are selling for a low price for a reason. They occasionally get hyped and soar briefly, but they usually plummet back to earth. Steer clear of the pennies, and focus on quality companies.

The Bottom Line

The bottom line is the nominal value of the share price bears absolutely no relation to the future prospects of the company. For the tiny amount of penny shares that have turned into massive winners, hundreds and hundreds more have failed completely, or at best, stay languishing as penny shares for years to come.

Much of investing is about putting the odds in you favour. Buying highly speculative penny shares on the chance they might quickly double in value is not our way of playing the odds game.

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