“If I had invested in so-and-so stock a few years ago, I’d be a millionaire by now.”
Everyone finds themselves thinking like this whenever one hears about a stock that was trading for pennies and then going through a mind-blowing growth period.
In 2021, one of the biggest stories that even attracted non-finance people was GameStop in the US market. GameStop used to be a penny stock trading in the range of $2 to $3 at a point in time. However, this all changed on the back of a random Reddit thread, where a community of traders interacted and discussed the stock. By January 2021, GameStop was already trading in upwards of $300.
Although good penny stocks that make it big are rare, the prospect is still very attractive. This article looks at the various advantages and disadvantages of investing in penny stocks.
What are Penny Stocks?
In India, penny stocks are defined as scrips that are trading below ₹10. They are known to have low liquidity and high volatility. They can give investors high profits, but their stock price movements tend to be difficult to predict. Therefore, penny stock investments are often considered speculative in nature.
Penny stocks are frequently used in fraudulent activities, like pump and dump schemes, where the stock prices are manipulated.
The Pros of Investing in Penny Stocks
- Low cost
Penny stocks trade for a very low price. Suppose the lot size of a penny stock is not so big that an investor needs to put forward a similar amount of capital as they would, with blue-chip stocks for a meaningful quantity. In that case, newcomers to investing will find penny stocks approachable as compared to investing in blue-chip stocks, which have larger per share price and huge volumes. You may invest in penny stocks without needing huge amounts of capital and yet attain a bigger volume.
- High Returns
New and small companies who haven’t made it big yet, may often start out as penny stocks. Investing in such companies before they make it big, and thereby reaping the returns makes penny stocks attractive. Good penny stock in Indian markets may give an investor the opportunity to make humongous profits.
- Chances of overnight gains
Penny stocks are issued by small companies that haven’t yet reached their potential. Suppose a case where a penny stock company suddenly enters the headlines for the right reasons (for example, good credit ratings, sound fundamentals, good management, good market positioning, etc). In that case, they might experience overnight gains in stock prices.
The Cons of Investing in Penny Stocks
- Unpredictable pricing
Predicting the price of a penny stock is very difficult due to limited information, infrequent trading and the scope of fraudulent activities. The price ceilings and floors are a lot more flimsy in penny stocks than blue-chip stocks. An investor may make a lot of money overnight. On the flip side, they may also lose it in even less time. Even the top penny stocks with high market capitalization may experience extreme volatility.
- Limited information
It is challenging to learn about a penny stock company’s financial soundness, management quality and overall performance. As compared to blue-chip companies, an investor will have a lot less research on their hand while making trading decisions in penny stocks. Often there is hardly any information about their historical performance as a business.
- Low liquidity
Even if you have never invested in your life, you can name at least one large-cap company just by looking around your room for some branded products that you may own. On the other hand, penny stocks do not enjoy this popularity. This is reflected in their low trading volumes. Low trading volumes make it difficult for investors to buy or sell penny stocks. An investor may feel locked in penny stocks as there might not always be a person willing to take the other side of the trade.
- Prone to scams
Due to the low trading volumes and stock prices, penny stocks are attractive for scammers aiming to manipulate the price to make profits at the expense of unsuspecting investors. Investors may lose significant amounts of money, due to some parties or groups manipulating the price.
Investing in Penny Stocks
Investing in penny stocks may often be like holding a lottery ticket. No sane person buys lottery tickets with all their savings. Investors should limit the portion of their portfolio they assign to penny stocks. Since the risk is high and liquidity is really low, invest only an amount as per your risk appetite. Due to the low trading volumes, there’s no guarantee that you will be able to pull out money in time to reap the benefits.
Ford Motor is a stock that is often talked about as a penny stock that surprised the investor community. In 2009, Ford Motor was trading close to $2 per share and bounced back to $10s by the end of the year. It should be noted that, in 2009, Ford was a 106-year-old company that turned into a fundamentally strong penny stock. All penny stocks may not have the same features.
You may be able to find Indian penny stocks with good fundamentals. Debt-free penny stocks with strong fundamentals may seem like potential multibagger penny stocks. But you should also keep an eye on the trading volumes. Investors should be careful and go the extra mile in their research on penny stocks. Along with fundamental research, investors must do technical analysis as well, if possible, to gauge the right entry and exit point.
Check out our guide to technical analysis of stocks.
It is rare for penny stocks to make it big. Low trading volumes make it difficult to trade in penny stocks. As a result, investors may find themselves locked in loss-making companies. The lack of information is also a deterrent to such investments. Therefore, investors must make sure to check the fundamentals of a penny stock and do their research before investing in penny stocks.
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Investing in penny stocks is very risky. Due to low trading volumes and limited information, there’s always a possibility of being locked in stock you may not have enough knowledge or confidence about.
Investors stand to make huge profits if penny stocks grow. However, that is a very big ‘if’. Often, there is minimal information about penny stock companies. Also, due to low liquidity, investors may find it difficult to pull out funds from penny stocks.
Penny stocks are risky due to limited information and low trading volumes. Limited information can make it challenging to learn about the business. Low trading volumes make it difficult to pull out money from penny stocks.