If you have a high-risk appetite, penny stocks might be a good investment. These low-priced shares usually belong to lesser-known companies and can prove to be multi-baggers. However, while investing in penny stocks can generate high returns it’s critical to be aware of the potential risks. Only a select few penny stocks turn out to be winners, but most of them are dubious investments. We investigate why they are so risky, how to best invest in penny stocks, and if there are alternatives to penny stock investments.
What are Penny Stocks?
Penny stocks typically trade at share price values below $5. These stocks belong to small companies that usually have very little information available in the public domain. Most of these stocks are traded in over-the-counter (OTC) markets. Only a handful of penny stock companies trade on the New York Stock Exchange (NYSE) or Nasdaq (NDX). Penny stocks are also known as micro-cap stocks, belonging to companies with a market capitalization of $300 million or lower.
Is it Profitable to Buy Penny Stocks?
While penny stocks can be profitable, they can also result in major losses. Penny stocks are highly volatile, with wild price fluctuations. As they have very low prices, a small price adjustment can result in a signifcant changes in the holding value.
For example, imagine you own 100 shares of $1 stock of company A. If the share price changes to $1.5, this will result in a 50% jump in the price. Your initial investment of $100 will increase to $150. Similarly, a fall in stock price to $0.60 will represent a 40% loss on the share.
Additionally, since penny stocks are mostly traded in the OTC markets, there is not much trading volume in these stocks. This means that you may not find a buyer or seller for these shares when you want to trade.
What is the Downside of Penny Stocks?
There are a few challenges to investing in penny stocks. As with any investment, it is very important to undertake thorough research. Unfortunately, information on most penny stock companies is not available in the public domain. This makes it easier for large investors to dump stocks as well as possible fraudster schemes to take place.
To safeguard your investment, it may be wise to invest in penny stocks that are traded on an exchange. These large exchanges require certain disclosures and accounting standards to be followed. This makes the listed companies accountable to a certain extent, although fraud can still happen in large well-capitalized companies as well.
What are Pump and Dump Schemes?
If you do invest in penny stocks, then beware of the “pump and dump schemes”! These schemes involve fraudsters pumping up stock prices by spreading disinformation about the companies. They hype the company on social media platforms, thereby luring naïve investors to buy the stock.
Once the demand-triggered price of these shares goes up, the fraudsters then dump their holdings in the market. This results in a period of share price plummeting. The losers are often small-time investors who make huge losses, with no buyers on the other side.
How Fraudsters Use Social Media in Pumping Stocks
Fraudsters often depend on social media platforms like Twitter (TWTR), Facebook (META), and Reddit to manipulate investors to invest in penny stocks, for their own gain. They use these social media sites to create a buzz about around a penny stock. This buzz attracts attention and people start to invest, pumping up a stock’s price.
The recent meme stock frenzy was a result of the free availability of information on social media platforms. Companies like Bed Bath & Beyond (BBBY), AMC Entertainment (AMC), and GameStop (GME) have seen their shares plunge to their lowest lows as well as skyrocket within a single day.
Memesters are taking undue advantage of social media platforms to make huge bets on these stocks and make massive profits. Meanwhile less experienced investors suffer huge losses.
How to Invest in Penny Stocks
If despite the danger, you want to invest in penny stocks, there are steps you can take to mitigate risk.
1. Invest according to your risk appetite – in other words, don’t invest more than you can afford to lose.
2. Don’t invest for the long term – unlike other stock market opportunities, penny stocks are rarely “Buy and Hold” investments. Keep an eye on penny stock investments so you can gain from short-term price fluctuations. A penny stock may not necessarily go on the up trend in the long run.
3. Don’t diversify – this may sound like the opposite of what you have learned about investing, however, it doesn’t hold for the penny stock market. When it comes to penny stocks, do not bet your money on multiple horses.
Imagine you invested $1000 in five penny stock companies and allocated 20% to each. If two out of the five stocks generate positive returns, you could end up losing all your capital.
4. Book your losses – don’t try to average purchases while investing in penny stocks. If a penny stock falls significantly in percentage terms, then it is usually better to take a loss and exit. A downward trend can often mean that there is something fundamentally wrong and the prices may not come up.
5. Buy only liquid stocks – this will ensure that you always have a buyer when you want to exit the stock. For instance, if the average daily volume of a stock is 100 shares over the past month and you own 500 shares, you may find it difficult to offload when you want to sell.
6. Broker commissions – try to invest in penny stocks through brokerages that do not charge commissions. The low gains on these investments may not justify the huge commissions paid to the brokers.
7. Do your own research – do not believe hearsay or follow meme stock frenzies, as this can put your money at risk.
How to Research Penny Stocks
There are stock research tools for researching penny stocks. The TipRanks Penny Stock Screener tool is one of the best. It presents a list of top penny stocks to watch. You can filter this list according to different data, such as how Wall Street analysts rate stocks, as well as their average price targets. This can help you pick attractive penny stocks.
Penny stocks often belong to the healthcare sector as upcoming pharmaceutical and biotech companies can have a small market cap. They are mostly in the clinical stage of drug development. These companies become overnight hot stocks should one of their drugs get the green light from the U.S. Food and Drug Administration (FDA). Similarly, the market is flooded with smaller fintech companies and banks that have the potential of being taken over. Look for such potential long-term winners in the TipRanks’ Penny Stock Screener list to make informed investments.
Here is a screenshot of some of the top penny stocks, with the highest upside, using the Penny Stock Screener :
Additionally, the screener showcases data, such as insider trading, hedge fund activity, retail investor sentiment. This unique data can help you make making informed investment decisions.
Alternatives to Penny Stocks
If you have a small amount to invest in the stock market and prefer lower risk investments, fractional shares may be best for you. Fractional shares have made it possible for investors to invest in well-capitalized companies, generally the biggies in their respective sectors. Fractional share investing is available for U.S. shares and exchange-traded funds (ETFs).
Imagine that you want to buy shares of technology giant Alphabet Inc. (GOOGL) but have only $1000 to invest. Fractional shares trading enables you to own a fraction of the shares of expensive companies.
Brokerage houses like Charles Schwab (SCHW) and trading platforms such as Robinhood (HOOD) have made this possible. The TipRanks Smart Portfolio also supports fractional shares, to give you better insights.
Furthermore, several large companies have undertaken stock splits to make their shares more affordable, attracting a bigger investor base. Overall, stock splits boost liquidity and make the stock affordable to smaller individual investors.
Final Thoughts on Penny Stock Investing
Investing in penny stocks is risky. However, if this is a risk you want to take, given the potential for outsized returns, then make sure you follow basic guidelines. Conduct your own research and only invest in stocks that have high volume to safeguard your investments. Use a penny stock screener that enables you to say analyst ratings and price targets for the best chance of finding safer investments.