By Patricia Uceda, Spring 2014 Student Intern
In The Wolf of Wall Street Jordan Belfort, played by Leonardo DiCaprio, becomes a millionaire overnight through the sale of virtually worthless penny stock to unsuspecting investors. If there’s one thing we can learn from this sordid tale of debauchery, it’s a better understanding of penny stocks and how they work.
What are Penny Stocks?
Penny stocks are stock that trades at a low price, $5 or less according to the SEC. Penny stocks are usually not registered with major market exchanges, and are considered to be highly speculative because they are sold by small companies with no track record. Since the companies are very small, penny stocks also have virtually no liquidity since there is not exactly high demand for the stock of an unknown company.
Initially Jordan Belfort, the Wolf of Wall Street, earns his money through 50% commissions on penny stock sales, using deceptive sale tactics to con inexperienced investors into buying large amounts of these unsecured stocks. As he gains more experience, he begins implementing massive “pump-and-dump” schemes. These schemes basically involve buying large amounts of penny stocks in a small company, driving up the price through vigorous sales efforts, and then selling back the stock at its new inflated price. A highly lucrative tactic, it is also highly illegal, leaving Belfort to serve jail time and his investors with nothing.
Because of the massive fraud incurred on these investors in the movie, you would think penny stocks would be on the decline. However, general interest in stocks has actually skyrocketed since the film, leaving us to wonder why. Part of the appeal of penny stocks is their low cost and seemingly endless potential for growth. As the old urban legend goes, Microsoft and Walmart were once penny stocks. However, those myths have been officially debunked, and the end result for investors is not usually as pretty.
What’s So Risky About Penny Stocks?
There are two major issues involved with investing in penny stocks. First of all is the lack of information available to the public. Since these are very small private companies, they are not required to make public disclosures with the SEC. Any information you do find may not be very reliable. Without credible information, it is hard for investors to make informed decisions before investing in penny stocks.
Secondly, as mentioned above, penny stocks do not have very much liquidity. When stocks don’t have liquidity, problems can arise. You may not be able to find a buyer for your stock when you want to sell, which may lead to you having to lower your price. In addition, low liquidity makes it easier for fraudsters such as Jordan Belfort to artificially inflate the price by buying large amounts of stock, hyping it up, and then selling it.
While penny stocks may look like an attractive option given their extremely low price and room for appreciation, ultimately they are extremely risky and investors should understand the significant risks and do their homework before entering the wolves’ den of penny stocks.