Seems harmless. Buy a hundred shares for $1.25 each, you're just risking $125 and if it goes up to $2.50 you've made 100% on your money. The percentage sounds great, but making $125 isn't really much, and you might have paid $60 in trading fees. So to make it worth your while, you might buy 1,000 or 5,000 shares.

Cheap stocks can be easily manipulated by someone talking them up in an internet chat-room. Called "pump and dump", it does happen. A stock that trades maybe 5,000 shares a day is easy pickings for these scammers. You can be tempted into buying at an artificially high price, then watch it drop 50% in just a couple of days. You also pay a higher spread to buy into a thinly traded company.

Historically, small-cap stocks, as a percentage of return on your investment, have outperformed large-cap stocks; not because a bunch of cheap, small companies are a better investment than big companies, but because almost all big companies were small when they first sold stock. But many (maybe most) large companies are all through growing and are just fighting for market share, such as Coca-Cola and General Motors.

Never, ever buy a low-priced stock just because it used to trade at a much higher price, hoping it will return to its glory days. You have to ask "why did the price fall so low in the first place?"

The market has thousands (yes, thousands) of disappointing companies whose stocks are not only trading below $10, but are headed lower. Relatively few of these stocks are heading back up.

A Merrill Lynch study looked at 1,900 stocks that had fallen below $10 a share from 1987 to 2000. On average only 1 out of 30 rebounded to over $15 during the next year after dropping under $10.
 

Avoid any stock that has fallen to under $10. Sure, it may recover someday. But why tie up your money in a company that may go nowhere for years. Wait until the company has proven itself and then pick the sensible point to buy.

There are many gems among the small-cap companies if you can spot the true up-and-comers.

Just because a company is small, and maybe its stock is priced low, doesn’t mean it should automatically be passed over. There are some young, quality companies, whose stock is trading for under $5 a share. It’s the stocks that have crashed from lofty heights that you should avoid like the plague.

I would like to emphasize that you can not tell if a company is a small-cap or a large-cap by its share price. Market cap is the share price times the number-of-shares available for trading. There are many quality small-cap stocks trading for over $20 a share.
 

Other Stock Market Basics Topics:

1. Stock Market Investing – the Right Way
2. More Stock Marketing Investing
3. How to Pick Winning Stocks
4. The Golden Rule of Investing
5. Avoid Psychological Traps to Have Successful Investing
6. Changes in Stock Values Can Be Big Numbers
7. How to Invest Smart
8. Stock Advice - Important Selling Rules
9. Poor Stock Buying Decisions
10. Market Indicators
11. Stock Market Cycles
12. When a bear stock market may not be a bear market
13. Stock Index Futures
14. Four Things that Affect Stock Valuation
15. What is a P/E ratio?
16. Value Investing
17. Cheap Stocks
18. What is a Financial Statement?
19. Analyzing Financial Statements
20. Stock Market Tip - Red Flags to Look For When Investing?
21. The Annual Report – How to Read
22. Stock Market Analysts – Stock Market Advice and Tips