Warning, Penny Stock Investors

As it is the case with any highly speculative situation, and particularly when penny stocks are involved, there is always an uncomfortably high probability of coming across at least some form of securities fraud. Although the days of aggressive telemarketers peddling all kinds of “extremely lucrative” or “must buy ventures” have pretty much been over since the 1980s, even in this day and age, some people still get caught up in their tricky webs, particularly the trusting seniors. Still, a 21st century investor should know better than to agree to buy a stock offered during an unsolicited, hard sell telephone call.

"Pump and Dump" Defined

Such calls most likely originated from the so-called “boiler rooms,” where aggressive salespeople, versed in siphoning people out of every penny they own, used to sit by rented and easily mobile desks, talking to hundreds of people on any given day. Such “firms" often bore names very similar to well-known brokerage houses on Wall Street, thus lending themselves an air of legitimacy.

It would all start with a simple call to a random name in the phone book, offering a stock that was a “sure thing,” or likely “to hit the roof by tomorrow.” Usually, there were no adequate analyses, no ratio calculations, no reliable target pricing, just a gut feeling of someone “who has yet to be proven wrong,” or a bogus promise of some remarkable technological breakthrough, or a fantastic story of the world’s greatest gold find, etc. Honestly, who could say no to promises of turning $10,000 investments into $100,000 or more, literally overnight?

Granted, while daydreaming of great riches, not many people could see through the elaborate shows these people were putting up. By the time people realized they have fallen victims to a manipulative practice called “pump and dump,” most of their hard earned money ended up far, far away.

What has really been happening behind the scene was that fraudsters were simply pumping up the price of some typically worthless stock and creating a completely artificial market for it. Once the alleged “flavor of the week” had hit the desired price level, they would dump it, pocketing their profits and sticking everyone else who came too late to the table with substantial losses. Although securities regulations have tightened the noose around the old-fashioned “boiler rooms,” various other forms of pump and dump still exist to this day.

Before Venturing into Penny Stocks...

In the spirit of honesty, it must be said that not all penny stocks are potential investment disasters and that not everyone recommending such stocks are scam artists. In the article titled “Making the Case for Small Caps,” it is explained why small capitalization stocks are usually not attractive to large brokerage houses, or hedge and mutual funds, why there is no generally available institutional research on small caps, and how small caps' unique status could create potentially profitable situations for your portfolio.

On that note, a truly independent research companies might be quite good sources of information for ordinary investors. The best case scenario is when independent research analysts are not affiliated with, or compensated by, the companies whose stocks they research and/or recommend. It represents one more safeguard against manipulation and securities fraud.

In spite of penny stocks’ lackluster reputation and in spite of many of them incurring millions of dollars in losses over the years, the fact remains there is still a large number of legitimate companies trading on the over-the-counter markets. Typically, we are talking about start-ups, but with exciting prospects, which, if you invested in them during their formative years, could yield you fantastic returns.

To cross to the other side of the rainbow, investors must gather as much information about the economic viability of companies' businesses, as well as critically evaluate their financial performances. Remember, not only should your prospective penny stock investment have enough cash to survive its formative years, but you should also invest only the money you can afford to lose.

A Bucket of Pennies is Often Just a Bucket

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