Rewards And Hazards Of Investing In Penny Stocks

Penny stock investing is considered most risky investment in equity markets. If we go by the historical data, we get some mixed signals on investing in penny stocks. Having said that, the outcome of penny stocks investing is almost always dramatic and extreme, to say the least. The chances are investor will either grow the money manifold by investing in penny stocks or the investor may simply lose all of his or her investments. Many believe the odds of losing the entire investment in a penny stock are far greater than hitting a home run and raking in huge profits. It is not very difficult to understand why investing in penny stocks is considered risky.

Penny stocks are often companies dogged by fundamental problems. These companies are usually scam hit, over leveraged, facing legal issues, operational issues and many more problems that impact the performance of the company negatively. These factors drag down the prices of penny stocks towards the bottom. The question is why invest in such companies when it is known that such companies may be facing multiple issues.



The lure for extraordinary returns in the short run is the only reason behind such a risky adventure. Says Rohan Bora , an investor with penchant for penny stocks, “I became a penny stock investor by accident. I initially purchased a couple of stocks for short term gains, but I soon realised I am holding on to them for the long term, even though I was losing my money from penny stock investments. One really needs to be sharp to predict a turnaround in a penny stock. It is definitely not an easy exercise, but it is a highly rewarding one. I think while investing in penny stocks, it is important to know when to sell. That to me is the most important aspect of penny stock investing.”

While it is possible to generate good returns in penny stocks, the basics of investments are most relevant while choosing to invest in penny stocks.

Who should invest in penny stocks?
With extra care and caution as one approaches penny stocks investing, building a portfolio of penny stocks may be a good idea assuming you as an investor are able to :

1. Analyse the financials of all the penny stocks under consideration
2. Ascertain that the source of information about the penny stocks is genuine and not coming out of promotional material
3. Understand the quality of management and believe in the revival plan that the company has put in place (assuming that most penny stocks are troubled companies)
4. Ascertain that the scamsters ('pump and dump' players or manipulators) are not targeting the company for their immediate gains 
5. Ascertain the overall market mood and which way the market is headed.

Usually penny stocks is the play area for market manipulators. The pump and dump strategy is used by scamsters which involves luring inexperienced investors into investing in cheap and worthless stock. What happens in such cases is that the promoters drum up interest in scarcely known or unknown stocks. The novice investors invest in such stocks, taking comfort from the positive statements on the stocks made by the promoters via some advertisements or newsletters. Once the stock skyrockets to certain levels, the scamsters start selling, leaving the ordinary investors high and dry.

These manipulations are not restricted to penny stocks alone, however, the frequency of such events can be higher in penny stocks and hence extra caution is warranted.

Penny stocks' performance:

For investors, it will be interesting to know how the penny stocks have performed in general over the past five years. The table below highlights the performance of the penny stocks across various periods. If we look at the data in the table below, the average performance of the penny stocks is not scary at all. 



If we consider top 10 performing penny stocks or even the top 50 performers in a 1-year time frame in the past five years, the results are more than impressive. The table below highlights how the top 10 and top 50 penny stocks have performed in one year in respective years. 





In the past one year, almost 87 penny stocks delivered positive returns with at least 19 stocks in the category gaining more than 100 per cent. 16 stocks generated returns in the range of 50 to 100 per cent, while there were as many as 17 stocks that gained in the range of 25 to 50 per cent. 

"Investors with high risk appetite and with penchant for financial analysis can look at penny stock investing opportunities"

Conclusion 

Needless to say, penny stock investing is not for the lay investors. Experienced investors who are able to perform financial statement analysis deftly and are able to judge the outcome of the strategy adopted by the company accurately have a chance to rake in the mullah by investing in penny stocks. Anyone who gets excited just by looking at the cheaper stock prices should stay away from penny stocks. Penny stock investing needs sophistication and merely looking at cheaper stock prices and investing in such stocks just because the prices are too low can be suicidal.

The focus should be on the situation analysis of the markets and a thorough fundamental analysis of the penny stock that is being considered for investment is essential. The performance of select penny stocks is encouraging across time periods and hence investing in penny stocks is encouraged only for those who are experienced investors and have spent considerable amount of time in the markets to understand the inherent risks involved in penny stock investing.

The first step can be to find a discount broker because the transaction costs are usually on the higher side when it comes to trading in penny stocks. The second step should be utilising a proper stock screener, which will help you narrow down the universe of stocks that suits your trading or investing style and diversification needs.