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About to buy penny shares? Here’s why the FTSE 100 is a much better bet

The first time anyone suggested investing in the stock market to me it was: “A few of us are thinking of getting together to buy penny shares, are you interested?

I had no idea what penny shares were, but I knew not to get involved in things I didn’t understand.

The attraction

I can see why people are attracted to them. After all, it seems intuitively more likely that shares in, say, UK Oil & Gas at about 2p each, could multiply tenfold rather than FTSE 100 giant AstraZeneca shares priced at more than £56 apiece.

As it happens, I agree, but I’m pretty sure that UKOG is also considerably more likely to go bust than AstraZeneca, as it’s exposed to some serious risks. It’s also essential to look beyond current share prices and check how penny shares got where they are, as it almost always takes some serious bad news to get down so low. In fact, UKOG shares have lost nearly 75% of their value in the past 12 months, which really highlights the risk to me.

The share price alone really tells us nothing about a company’s prospects anyway, as it’s just based on an arbitrary division of the company. AstraZeneca, for example, could do a 2,500 for 1 stock split tomorrow and have its shares valued around the same as UKOG’s — but it wouldn’t make any difference to the stock’s likelihood of ten-bagging.

Likewise, UKOG could do the opposite share consolidation and swap 2,500 old shares for one new one priced at around £55, and that would affect the prospects and the risk not a jot.

Lots of losers

I’ve just had a look over the AIM index, which is home to more than 750 companies, mainly tiddlers, and 78 of them have shares currently priced at less than 1p. Increase that to a limit of 2p, and we see 119 companies. I then selected 10 of those companies at random, and every single one has seen its share price crash to today’s price.

And all bar one of them is currently losing money, most at quite a worrying rate. I reckon the chance of most of those going bust is significant. And even for the those that will make it, there’s no way to put a proper valuation on the shares today. Are they worth £1 each, or 0.01p? We just can’t tell

On the other hand, pick 10 companies at random from the FTSE 100 and you’ll find all bar one, Ocado, currently forecast to make a profit in 2018. And there’ll almost always be years of earnings and dividends to inspect, with meaningful measures like P/E multiples and dividend yields. Putting a valuation on FTSE 100 shares is still tricky, but it’s a lot easier than with loss-making penny stocks.

Gambling, not investing

Penny share investors tend to over-react to news too, both good and bad. Something upbeat happens and the get-rich-quick crowd piles in, pushing the shares up too high — then there’s a disappointing update and the price crashes again. And so many people believe they’re good at timing the market and can get in and out at a profit each time. Well, I’ll tell you something for sure right now… you can’t.

No, investing in penny shares is gambling, pure and simple, and that’s not the way to secure a comfortable retirement. It’s the FTSE 100 for me.

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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has recommended AstraZeneca. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.