Introduction

There is a human tendency to get attracted towards things that are available at a cheap price. Since investors too are humans, they too get attracted towards what we call cheap stocks or penny stocks.

Penny stocks are most popular among retail investors because they are available at cheap prices and the potential upside is unlimited. 

But are you aware of the risks that come with penny stocks? In this article, we will cover penny stocks in detail.

What are penny stocks?

The word “Penny” is derived from a US unit of currency called penny which is equivalent to 1/100th of a US dollar. 

Basically, penny stocks are shares that trade at a very low price. These companies have a very low market capitalization.

The definition of penny stocks varies from country to country. In the US, those shares that are trading at less than $5 are considered as penny stocks.

In India, the stocks that trade below Rs 20 are penny stocks.

The companies are also classified on the basis of market capitalization. Companies that have a market cap of more than 20,000 crores are large cap companies.

Companies that have a market cap between 5,000 – 20,000 crores come under the category of mid cap companies and those having a market cap of less than 5000 crores are classified under small cap companies.

Penny stocks are basically companies that have a market cap of less than 5000 crores.

Features of penny stocks

Following are the features of penny stocks:

#1. Ill- liquid

It is difficult to find buyers and sellers for penny stocks because they are relatively unpopular among the investing community. 

It becomes problematic when you are in need of funds urgently and you don’t find any buyers.

#2. Low price

Penny stocks in India usually trade at a price lower than Rs 10 or 20. Some of them even trade at a price less than Rs 1. 

This results in a temptation among retail investors to buy a greater number of units of the company.

#3. Limited information

Penny stocks are usually issued by companies that are relatively new. Thus, there is very limited information available about them in the market.

This makes it difficult for investors who look at the past performance of the company before investing.

#4. Unpredictable price

Penny stocks are very unpredictable by nature. The price can either go very low or very high which makes them a risky investment.

How to spot a potential penny stock?

Because penny stocks are very difficult to buy from the open market because of the spread between the bid and ask price, they are usually bought by investors from brokers and dealers instead of the open market.

The bid price is the price at which the dealer is willing to buy the stock from you whereas the ask price is the price at which he is ready to sell you the stock. The difference between the bid and ask price is called spread.

The wider the spread, the more expensive and riskier it is for the investor who is willing to profit from the price appreciation of the stock.

The best way to spot a penny stock is conduct a thorough research on the company and see whether it has the potential to turn into a multi-bagger given that it is trading at a very low price currently.

You can also study the companies that have turned from being a penny stock to a multi-bagger. If the potential company has similar features like these, you can consider investing in it.

Advantages of penny stocks

Following are the pros of penny stocks:

#1. They are cheap

Since penny stocks are available at dirt low prices, even the small investors can purchase thousands of units of shares – an option that is typically available to only institutional investors.

This gives a chance to individual investors to buy a significant stake in such companies. Some penny stocks also offer voting rights, which enables the investor to control how the company is governed.

#2. Room for growth 

It’s the young companies that issue penny stocks which means they have plenty of room to grow.

Penny stocks also benefit more than stocks on the major stock exchanges from gaining investors’ attention since most high-quality penny stocks remain undiscovered by the majority of traders.

#3. Volatile in nature 

The volatile nature of penny stocks is an advantage for the short-term traders. These stocks soar massively in a very short period of time.

Day traders and swing traders often target penny stocks because of their high volatility.

Disadvantages of penny stocks

Following are the cons of penny stocks:

#1. Most penny stocks are junk

Most of the companies that issue these penny shares are either financially unstable or have an unsustainable business model.

Majority of penny stocks fail and go bankrupt. The probability of finding a winning penny stock is very thin.

#2. Volatile in nature

The volatility of penny stocks are like a double edge sword. If they can rise in value quickly, they can also lose extreme value quickly.

Trading in penny stocks should be avoided if you are risk averse. You should trade in penny stocks with the assumption that you might lose your entire capital.

#3. Low trading volume 

Penny stocks share very few trading hands on any given day. You might have a hard time finding a buyer if you are looking to sell a large volume of shares.

Since they have a very high bid-ask spread, you might be forced to sell them at a price much less than the market price.

Can you make money on penny stocks?

Although very risky, penny stocks can be profitable if you invest in them cautiously.

You should avoid certain fallacies that are common among trading communities such as believing that they have an opportunity to make large gains. They need to remember that there is an equal probability of making huge losses.

Another fallacy to avoid is the low-price fallacy, which holds that if low-priced stocks are cheaper than the high-priced ones.

One drawback of penny stocks is that even if the price of share multiplies, it may be impossible to sell a large stake without price slippage i.e., the difference between the bid and ask spread.

Tips for investing in penny stocks

Before you invest in penny stocks, keep these points in mind.

#1. Don’t trust blindly 

It is very easy to get manipulated by the reports provided by the penny stock companies. Do not fall for the gullible picture provided by the company and always dig for extra information through press releases, news portals etc.

Ensure that the data you use to make investing decisions is verified by a reputed authority.

#2. Monitor regularly 

Unlike big chip companies, you cannot just buy penny stocks and forget about them. You have to monitor their price movement due to their risky and volatile nature.

You need to be proactive when dealing with penny stocks.

#3. Diversify your portfolio

You can diversify your portfolio by investing across four to five penny stocks. Also, to spread the risk you can consider investing in less risky and fundamentally strong companies.

However, diversifying reduces the impact on your portfolio even if a penny stock performs phenomenally.

#4. Draw a line

Never invest all your money in penny stocks. Ideally, not more than 5% of your portfolio value should come from penny stocks.

What are the risks associated with penny stocks?

Apart from the basic risks that come with any market-linked security, there are some exclusive risks that are associated with penny stocks. These are:

#1. Limited data

Since most of the companies that issue penny stocks are start-ups or companies with a very low market cap, there is scarcity of information on their past performance which makes it difficult to predict their future performance.

Lack of financial information such as P/E ratio, free cash flow, debt to equity ratio, yearly revenue, etc. make it difficult to predict the actual worth of the company.

Therefore, along with thorough research, always dig for extra information before investing.

#2. Scams 

Penny stocks are often issued with the intention of scamming the investors. One such popular method of doing it is “Pump and dump”. 

The members of the company and scammers purchase the shares in large volume which creates a value inflation which attracts the other investors to follow the hype.

Once there are enough buyers invested in the stock, the scammers dump their shares which results in an immediate drop in the value followed by losses on the investor’s end who try to sell it.

If a penny stock is actually genuine, then the company will give enough information which will make it easier for investors to make an informed decision.

#3. Unpredictable price 

Since there is no data available to predict the performance of the stock, it becomes extremely difficult to predict the price movement of penny stocks. 

The price can move in either direction which makes it a risky investment option.

What are the alternative options to penny stocks?

Investing in penny stocks is not a feasible option for everyone. Different investors have different risk appetites. Investors can look for different investment options based on their financial goals.

One option that is gaining popularity in the market are mutual funds. Within mutual funds, there are different categories open to investors. 

Based upon risk appetite, here are some mutual fund options that you can consider investing in:

#1. Hybrid funds

These funds are a mixture of equity and fixed income securities. The risk and return varies depending on the constitution of debt and equity. 70:30 of debt and equity securities is the most ideal ratio for risk averse investors.

Those who are comfortable with little extra risk can opt for a 50:50 or 30:70 of debt and equity ratio. Hybrid funds are a great option to diversify portfolio and create a balance between the reward and risk.

#2. Debt funds

These funds invest only in fixed income securities like government bonds, treasury bills, etc.  Although there is minimal risk, the potential return is also limited in debt mutual funds.

#3. Equity funds

These funds invest in equity of large and mid-cap companies listed in the market. These funds generate more returns compared to debt mutual funds. They entail lower risk in comparison to penny stocks.

Conclusion

It is crucial that you are well prepared before investing in penny stocks. 

Since penny stocks are risky bets, avoid committing a large portion of your capital to it. Allot only a small portion of your portfolio in penny stocks and that too after adequate research.

You might have heard stories of people becoming millionaires by investing in penny stocks but what you don’t know is that it happens in very rare circumstances.