One of the hardest lessons for investors to grasp when it comes to penny stocks is that just because a stock appears to have a lot of upside potential, it isn’t necessarily well matched with their risk tolerance.
What’s more, self-serving fraudsters will sometimes promote penny stocks illegally in what are known as “pump-and-dump” schemes.
And even when penny stocks aren’t part of an illegal scheme, jumping to invest in these cheap equities isn’t always a good idea.
Think of all the retail investors who drove up the share prices of Whiting Petroleum, car rental company Hertz Global Holdings and retailer J.C. Penney – companies that all filed for bankruptcy during the earlier days of the COVID-19 pandemic. Some investors made a bit of money on these trades. Some made a lot. Others lost money, even though those losses could have been avoided if they’d made informed decisions to only buy stocks that matched their personal investment horizon and risk tolerance.
How it works
Advisors and brokers are able to recommend stocks for clients and it is not unethical to do as long as the investments are suitable based on the investor’s goals, objectives, time horizon and risk tolerance.
If an investor wants to buy penny stocks through an account that is overseen by an investment advisor, all trades are subject to industry “Know Your Client” (KYC) rules, including a section on risk tolerance.
“If the trades are not in accordance with the ‘Know Your Client’ form you completed” either the broker or the compliance department should raise the issue, said Eric Kirzner, a finance professor with the University of Toronto’s Rotman School of Management.
“The advisor is supposed to act in your best interest.”
If the investment isn’t suitable, Kirzner adds, the broker should explain why that is or potentially refuse to manage the account.
But, “if the retail investor is trading online directly themselves, there’s nothing to prevent them from buying crappy stocks,” he says.
“There’s nobody to stop you if the trade is inconsistent with your risk profile or you’re trading on your own. (You’re) allowed to shoot yourself in the foot.” While not everyone needs or wants an advisor this is definitely one of the areas in which the value of advice cannot be overstated.
RBC Direct Investing said in an email that “as an online brokerage for self-directed investors”, it cannot, “under regulatory requirements…provide investment advice or suitability recommendation(s).”
According to the Investment Industry Regulatory Organization of Canada (IIROC) regulations, so-called Order Execution Only (OEO) firms are actually prohibited from offering recommendations to their investors regarding a particular security or even class of security.
What additional safeguards should be in place to protect investors? This remains a tricky question and is one that the industry has grappled with for many decades.
Kirzner says he supports the idea of having online brokers issue a warning if an individual attempts to buy a risky penny stock, but he also thinks it’s too intrusive to actually prevent investors from ultimately going ahead with a trade.
Andrey Pavlov, a finance professor from Simon Fraser University’s Beedie School of Business, points out that a warning system could lead investors to think that any stock without one was safe – which might not be the case.
Ultimately, “a company (i.e. an online brokerage) is going to start putting warnings all over the place” to protect themselves, says Pavlov. At which point, “the warnings become largely meaningless.”
That said, Pavlov believes that brokerage firms could require investors to have a certain level of liquid wealth and a minimum of , for example, three years trading experience before they could buy penny stocks.
“I’d be more comfortable with that because it’s more about the investor and their experience and risk tolerance than the companies,” he adds.
As it stands, investors need to know that when it comes to trading penny stocks or any other distressed securities, if they’re doing so on their own, the current regulatory regime basically comes down to little more than “buyer beware.”
That’s something anyone who bought Hertz when it touched $6.25 probably knows all too well. Three months later, the stock was trading at just $1.33, no doubt leaving some adventurous traders with significant losses.
The Hertz episode — just one in a host of penny stock sagas that have burned investors — suggests that the current regulatory system doesn’t sufficiently safeguard investors.
Perhaps brokerage firms and securities commissions need to do more to protect people from themselves. While some investors lost their shirts on Hertz, it was not through any illegal action — which suggests there is a need for something more than a casual warning for these kinds of trades.