One of the time-honored mantras of the investment community is; the higher the risk, the higher the reward. But that is not, strictly speaking, an accurate statement. You can assume a great deal of risk without the potential for great reward. Better stated, the old adage should say: the higher the potential reward, the higher the risk. Penny stocks, those selling for less than $5 per share, typically involve higher-than-average risk in exchange for greater potential reward. The penny stock market requires lower reporting standards than listed exchanges, making it easier for scammers to ply their trade.
Avoid "hot tips." A common scheme involves you getting a voice mail from a supposedly misdialed number. The caller leaves "valuable" information for his "friend" about a stock that's about to explode, urging him to buy now before it's too late. The U.S. Securities and Exchange Commission refers to this as a variation on the old "pump-and-dump" scheme where promoters claim inside information about a stock. These hot tips are designed to create a buying frenzy, and with low-priced, sometimes thinly traded penny stocks, it doesn't take much to artificially inflate the stock's price. The scammers sell at the high, leaving investors to take the hit when the stock falls back to it's normal price. Trading on a hot tip is always bad business. If your contact really does have insider information, trading on that info is illegal and you could wind up in jail. But more likely, a hot tip is just another scam designed to separate you from your money.
Resist high-pressure sales tactics. There might be such a thing as a once-in-a-lifetime opportunity, but more likely if a broker tries to pressure you into making an investment decision right this minute, it's a scam. Be particularly wary of any claim of spectacular growth or confidential information. If the broker promises a guaranteed return on your investment, walk away. In the investments world, there is no such thing as a guaranteed return. If a penny stock appears to be too good to be true, it is.
Do your own research. Penny stock scammers can say anything they want, and might even back up their claims with official looking press releases touting sales, revenues, acquisitions and new product development. Never take an investment at face value. Depending on such factors as the company's size and the amount of stock they offer within a 12-month period, it might not have to file standard reports with the SEC. The lack of reporting doesn't automatically mean a company is involved with a scam, but it does make it harder to find the information that allows you to make an informed investment decision. If you can't find the information you need from the SEC, your state's securities regulator, public sources or the company itself, walk away. It might not be a scam, but you never want to invest in anything you don't understand.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.