If you have ever asked a friend for stock market tips, chances are that you have been recommended one of those "very cheap" stocks that can grow "10x". Essentially what your friend recommended you was a penny stock. A penny stock, as the name suggests, is a stock that trades for pennies, meaning a stock with very low prices. Most novices who make the mistake of thinking that low price means cheap stock put their money in these penny stocks with the hopes that it will shoot to the moon and more often than not, their dream rocket burns and crashes much sooner. It's then that they realize that the illusion of cheap price was just that- an illusion.
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So what are penny stocks exactly?
For any stock to be known as a penny stock, it should have:
Low stock price, generally less than $5. In India, penny stocks are those priced under 10
The company is a small or very small company in market capitalization.
Small cap companies also have small market cap but their stocks may or may not have low price. So they may or may not be penny stocks. Many penny stocks trade on stock exchanges but many others don't and you can buy them 'over-the-counter'
Why do people buy penny stocks?
Greed, of course. There are generally 3 big reasons why people think penny stocks are great bargains.
1. They are cheap
Because the penny stocks are priced very low, people conceive it as "cheap". Mixing price and value is one of the top stock mistakes people often make. Also, people find some sort of satisfaction in owning 10,000 shares of a $1 stock rather than 1 stock of $10,000. But yes, if you only have a $100 to invest, you can't buy a stock priced $200 (unless fractional stocks are allowed). So penny stocks are often used by people with low capital who can't buy a good enough quantity of larger blue-chip stocks.
2. People think they won't lose much
Somehow people think that because the stock is cheap, they will not lose a lot. It is, of course, not true at all. You can lose $10,000 if you have 10,000 shares of $1 just like you will if you had 1 stock of $10000.
3. Sometimes, they work like miracles
This is the most important reason behind the popularity of penny stocks among retail investors. Since penny stocks generally belong to very small companies, it is possible that a growth phase in the company may end up appreciating the stock price dramatically in a very short time. (It also happens for other reasons, few of which are reasons mentioned below to avoid these stocks). This leads to tremendous gains for few lucky investors. Such stocks also tend to have big circuit limits so they may end up going up 20% or more in a single day. Often, such stocks hit circuit after circuit due to their low liquidity leading to massive upside sometimes.
So what's the problem then? Doesn't it all sound just perfect? Well, there are more cons than pros to penny stocks. It is important to consider the risk before going crazy about the rewards.
Why should you avoid penny stocks then?
1. Liquidity and circuit limits: The biggest advantage of penny stocks is its biggest risk
Since penny stocks low liquidity and high circuit limits, they tend to accelerate up in the right circumstances and give amazing returns. But the same features of penny stocks also end up making them huge money traps. Because of low liquidity, it is very difficult to buy and sell these stocks while high circuit limits ensure they tend to fall as quickly or even faster as they go up. The same way penny stocks may hit one upper circuit after another on a good news, they may also hit one lower circuit after another leaving you trapped, sometimes not even giving you the chance to get out. So, even if you make the right move and invest at the exact right time and the stock has gone up maybe 2, 3 or even 5 times higher, it is possible the rising star may start falling and before you know, all your profits are gone and you even risk losing your money.
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2. Limited information
Often, penny stocks belong to very small companies for which you may not be able to get enough information to make informed investing decisions. Fundamental analysis of such companies may be difficult. This makes penny stocks unreliable for long term or even medium term investing.
3. Scams
A rising penny stock incites the greed among investors like nothing else. That beautiful sight of a series of upper circuits and every investor goes, "Take my money too". This is exactly why it is very easy to manipulate these stocks. Penny stocks are often a part of "pump-and-dump" scheme where insiders or scammers "pump" up stocks by buying massive quantities at low prices. This leads to that beautiful steep rise that pulls in retail investors. With greed in their eyes and money in their hands, retail investors buy these pumped stocks just like the scammers intended, taking the price even further up until finally the bubble bursts. The scammers then offload all their shares at high prices to the retail investors and the investors suddenly realize they have no one to sell their shares too. Add to this mixture low liquidity and huge circuit limits and the stock plummets like a comet. Investors lose their money while scammers enjoy the fruits of their scammy brains.
Bottom line:
Penny stocks are like a lottery ticket. You may win big or you may lose all your money. Penny stocks are prone to a lot of 'pump and dump schemes' and fraudulent activities. Sometimes, you may find gems in penny stocks which eventually end up becoming big companies. But finding such companies is as difficult as finding a needle in a haystack.
Remember the number one rule for investing - Return of capital is more important than return on capital. Preservation of capital is the most important thing in your investing journey and penny stocks may be detrimental in this regard.
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