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Why 'cheap' stocks are for suckers

Human beings may be apex predators with senses we can’t begin to articulate, but we are simply terrible at calculating odds. We wager too heavily on underdogs, line up like sheep to play Powerball and have collectively built one of the glitziest cities in the world right smack in the middle of the Mojave desert by playing games with odds openly stacked against us.

Couple that with our insatiable desire to feel smarter than our peers and you have the primary motivations for trading glorified penny stocks. Jonathan Hoenig of CapitalistPig marvels at the gullibility of otherwise savvy individuals.

“Maybe it’s an ego trip or something, but people love the idea of owning 10,000 shares of a terrible $2 or $3 stock.” Hoenig says in the attached clip. Like most born traders Hoenig sticks to probabilities. As he sees it, if a stock has managed to drop below $4 a share there’s probably a very good reason, and it’s not the foolishness of every single other person in the stock market not understanding the fundamentals as well as you do.

The only caveat is that dollar value per share doesn’t tell the whole story. It’s market cap, not share price that determines the size of a company. Asset spin-offs and industry wide crashes can drive otherwise respectable companies into the low single digits, but examples of companies that have come back from the dead are few and far between.

Before you’re tempted to take a flier on a $1 stock because of its former reputation, consider the greatest reverse-split $4 stock in recent history: Citigroup (C). During the financial crisis Citi melted all the way from the $50s to under $1.50 per share. To mask its ineptitude management decided to do a 1 for 10 split. The move inflated the sticker price but didn’t change the nature of the organization.

Six years after the meltdown Citi shares are still 90% off their all-time highs. That’s right, Citi is actually a $4.80 stocks disguised as a $48.00 grown-up bank. Unlike JPMorgan (JPM), Goldman (GS) and other major banks that had less help from the government, Citi is no where near getting back from whence it came.

As a rule of thumb use the hat size guide. The smallest children’s hat comes in a size 6. Any stock that falls below the hat size range is probably unworthy of your portfolio.

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