The Growing Danger of Penny Stocks

There has been a proliferation of penny stock schemes in the past few years, especially lately.

You've probably received emails promoting a stock that's the next “surefire winner,” selling for less than $1 a share, known in the investing world as penny stocks. All you have to do, the email says, is contact a certain broker or online service. Or maybe you’ve heard friends or colleagues talking up hot stock tips they’ve received for small companies whose shares sell for pennies.

These days, crooks are eager to separate you from your money by persuading you to buy these seemingly underpriced investments. But you need to avoid these ruses.

Stocks Sell for Pennies, Crooks Make Millions

The stocks may cost pennies, but the perpetrators of these frauds can rake in millions.

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One scheme that ran from 2007 until 2010 netted four individuals $17 million, the Securities and Exchange Commission has alleged. In another, federal officials uncovered a penny stock “pump and dump” gambit that made use of more than 15 websites as well as Facebook pages and Twitter feeds. The defendants fraudulently talked up the stock prices (the pump) and when the price got high enough, pocketed some $3 million by selling the inflated shares (the dump) to unsuspecting investors who ultimately lost $7 million.

Here’s the thing: Penny stock frauds are like cockroaches. When one turns up, there are sure to be plenty more around. And now that small investors are returning to the stock market, penny stock promoters are fleecing customers who hope to turn quick profits.

Ponzi Schemes and ‘Pump and Dump’ Scams

Scammers have long found penny stocks fertile territory for Ponzi and pyramid schemes, “pump and dump” operations and the like. (You can get a good feel for the market by watching the movie Boiler Room.)

The lure of penny stocks is obvious: a potentially huge, fast payoff from a cheap, speculative bet. For a small outlay of cash, say $500, you can buy 50,000 shares of “The Next Apple!!!” and “get in on the ground floor” before everyone else. At least, that’s the sales pitch. All too often, however, you’re left owning worthless shares after the insiders and paid promoters have scooted off with their profits from gullible investors.

Regulators from the FBI to the Financial Industry Regulatory Authority all urge investors to exercise extreme caution. Don’t believe the email hype. Be sure to independently verify any claims made by a stock's promoter and beware of high-pressure sales pitches.

My View on Penny Stocks

Good advice. But I’d go even further. I don’t think it’s worth the time and the effort to separate the market's diamonds from the cubic zirconia. When it comes to penny stocks, I say, avoid them.

If you want to own stocks, there are plenty of blue-chip investment-grade companies with real employees, goods and services that are traded on major stock exchanges. Many pay out real dividends, too.

Of course, there are many legitimate companies in the over-the-counter market, where penny stocks are usually traded. A reasonable rule of thumb is to stick with shares of actively traded companies sold on a reputable exchange — the NYSE and NASDAQ, for example. The firms should have at least $500 million to $1 billion market capitalization, a traditional benchmark for “small cap” stocks. (Market capitalization is the value of a business based on multiplying the number of its shares by their current price.)

Don’t Let Your Parents Get Fleeced

Boomers should be especially vigilant with their parents about penny stocks. About a third of all fraud victims are seniors, who can be especially susceptible to emails promising quick riches.

The Investor Protection Trust, a nonprofit focused on investor education, estimates that more than 7 million Americans over 65 — that's 1 out of every 5 — have been taken by a financial swindle, as Martha Deevy, senior research scholar at the Stanford Center on Longevity, wrote in a Next Avenue article.

How Penny Stocks Have Changed

Penny stocks aren’t new, but their game has evolved over the years. When I went to Businessweek in the mid-1980s, I reported on penny stocks. At that time, they had gone from primarily Mountain State mining shares to a national enterprise driven by a mad rush for stocks, especially tech stocks. (Many of my friends told me about getting cold calls from penny stock brokers, usually around dinnertime, asking for the “man in the house.”)

(MORE: Lowdown on Scams, Schemes and Swindles Targeting You)

A major force behind the '80s boom was Meyer Blinder, the self-proclaimed “King of Penny Stocks.” His brokerage firm, Blinder, Robinson & Co. was known on Wall Street as “Blind 'em and Rob 'em.” It closed in 1990; two years later Blinder was convicted on six counts of racketeering, money laundering and securities fraud.

In the '90s, Businessweek investigative reporter Gary Weiss uncovered a Mob-dominated nationwide web of stock promoters and boiler rooms, dealing mostly in penny stocks. Since then, the Internet and social media have vastly expanded the reach of penny stock promoters.

A Long-Term Bull Market?

Over the past few weeks, the business press and Wall Street commentators have vigorously debated the recent surge in stocks. Is it the beginning of a long-term bull market (a so-called secular bull market), as some maintain? Or are we witnessing a fleeting bout of exuberance that will quickly cool?

We’ll eventually find out. In the meantime, here's one thing you can know for sure: Financially prudent investors should stay away from penny stocks.

Chris Farrell is senior economics contributor for American Public Media's Marketplace. An award-winning journalist, he is author of the books "Purpose and a Paycheck:  Finding Meaning, Money and Happiness in the Second Half of Life" and "Unretirement: How Baby Boomers Are Changing the Way We Think About Work, Community and the Good Life." Read More