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A Short History of Penny Stocks

Video transcript is provided below: 

There’s never been a shortage of investors looking to “make a quick buck” off the latest stock tip – or of stock promoters looking to sell them the next big thing. 

But none are as dangerous as penny stocks – the stars of pump-and-dump schemes.

Penny stocks are shares of a company that trade for a very low price – usually anywhere up to $5 dollars.

Their price tends to fluctuate widely, which is what attracts investors looking to get a very high return very quickly.

These stocks tend to belong to companies that have small market capitalizations, little to no profits and limited public domain information or financials.

This makes them a lot more susceptible to price manipulation and pump-and-dump schemes, since they often trade over the counter (OTC) and not on recognized exchanges. As a result, they are less regulated and require less disclosure. 

While the stocks themselves aren’t illegal, fraudsters will use false and misleading information to inflate the price of the stock (pump), sell it at a higher price to unsuspecting investors, and then sell (or dump) their own overpriced shares so that the price falls and investors lose all their money.

The SEC and the Financial Industry Regulatory Authority (FINRA) have specific rules to define and regulate the sale of penny stocks. Both of these entities were created in part to provide oversight directly as a result of the 1929 crash, and the SEC has been trying to ensure fair trading ever since.

But those efforts haven’t been enough to keep more pump-and-dump schemes from popping up.

One study found pump-and-dump schemes cost American investors between $3 billion and $10 billion annually. 

One of the most famous examples of stock manipulation was Bre-X Minerals. The Canadian mining company’s stock was valued at a penny before its geologist falsified a record gold discovery, which catapulted Bre-X market cap to $6 billion. When he disappeared and was later found dead, the stock plummeted and eventually went to zero. 

In the U.S., Enron engaged in a massive pump-and-dump scheme (among various other illegal activities), using anonymous messages on online chat boards to suggest an inflated stock price for the company’s shares and used questionable accounting practices to overstate earnings so that more than two dozen executives were able to sell their overvalued stock for more than a billion dollars before the company went bankrupt. Enron is a rare example because the company wasn’t a penny stock when the pump and dump happened, but the principles remain the same.

There are now bulk emails or subscription-based lists/sites that work as the most effective way to hype shares of little-known companies.

AwesomePennyStocks promoted at least 39 different companies and their stock between 2009 and 2013, according to emails sent to investors. 

The value of those 39 stocks increased by more than $3 billion while AwesomePennyStocks was promoting them. Most of the shares went on to trade for less than 1 cent each and the company shuttered its operations in October of 2013. 

There is no intelligent reason an investor needs to trade penny stocks or hold them in any type of portfolio. The risks are too great to offset any perceived benefits. The draw of penny stocks has always been about cashing in quickly, but anytime something seems too good to be true, chances are that’s because it is.