Have you ever wondered whether or not penny stocks are a worthy investment for your portfolio?
Perhaps you’re intrigued by the stories of investors who claim to have hit the jackpot, earning triple digit returns in just days or weeks, not to mention the horror stories of others who seemingly lost every “penny” they ever owned.
Or, you may be wondering, “What is a penny stock in the first place?”
In this article, I’ll review everything you need to know about investing in penny stocks. What they are, who should and shouldn’t buy them, and how they fit in your portfolio.
I’ll also cover some of the risks involved, and share some helpful tips for buying penny stocks.
What Are Penny Stocks?
The definition of a penny stock has evolved over the years. They were once considered to be any stock trading for under a dollar per share, although that threshold has now increased to five dollars.
But this explanation is fairly limited. By taking a closer look, you’ll find that penny stocks share a number of characteristics over and above their low share price.
The Characteristics Of Penny Stocks
You Are Buying Small Companies
A penny stock is the stock of a very small company, otherwise known as a small-cap. Small-caps often have values below $50 million dollars, making their stocks far riskier than those of larger, blue-chip companies, such as banks or well known brands like Apple, or Toyota.
Penny Stocks Are Highly Speculative
Another factor that contributes to the risk of penny stocks is their speculative nature, which makes them highly volatile. As a result, the value of a penny stock can fluctuate wildly, up or down.
This is partly because small caps are not yet established in their respective industries. They are most often emerging companies, or startups, fighting desperately to grasp a small piece of a very large pie.
They tend to carry high levels of debt, have minimal cash resources to fall back on, or are betting big on new and unproven technologies. At any time, the possibility of going bankrupt can be very real.
Simply put, when you invest in a penny stock, you are betting on that company’s ability to overcome some pretty serious obstacles.
Penny Stocks Are Not Traded On A Stock Exchange
Unlike the shares of major companies, penny stocks don’t sell on the major stock exchanges, such as the TSX, or NASDAQ. Instead, they are traded on the-over-the counter (OTC) market.
What Is An OTC?
An over-the-counter market involves a transaction between two parties, without the oversight of an exchange. Instead, a company or individual known as a ‘market maker’ facilitates trades at a specific buy or sell price, with the goal of making a small profit on each transaction.
OTC’s are also used to trade other types of investments, such as bonds, currencies, and derivatives.
Penny Stocks Lack Liquidity
An OTC offers less liquidity than buying on a major exchange. They don’t offer the same level of transparency, making it difficult to establish fair market value, as the prices at which penny stocks are traded are not always published. Also, it can be tough to find a buyer for your penny stock.
Penny Stocks Are Risky
I can imagine what you’re thinking. With all of the risks involved, why would anyone want to put their hard earned money into a penny stock?
Who Should Buy Penny Stocks?
Penny stocks may be an option if you are seeking growth opportunities within an already well-diversified portfolio.
If you have the time to do the research, and actively trade (more on this below), you have the potential to strongly outperform the market with penny stocks.
The key, however, is for penny stocks to only comprise a small portion of your overall holdings, no matter how sophisticated an investor you are.
They are far too risky, a gamble at best, to be heavily weighted inside your portfolio. In other words, you have to be willing to lose any money you invest in penny stocks.
That said, providing that you limit your exposure, penny stocks can enhance your potential for increased overall returns.
Penny Stocks Are For Active Traders Only
Penny stocks are not conducive to a buy-and-hold investment strategy. They are far too speculative, with the underlying companies often suffering from a short lifespan.
As such, a penny stock investor should be an active trader, someone who is willing to devote a substantial amount of time researching the companies they are investing in, and is able to trade with great frequency.
When To Avoid Penny Stocks
As I mentioned above, penny stocks are not suitable for buy and hold investors. If you are not prepared to invest the time required to be an active trader, it’s best to steer clear.
Also, if you tend to be risk averse, avoid penny stocks altogether.
Beware Of Penny Stock Scams
Unfortunately, penny stocks are prone to some popular scams. Because of this, it’s important to know what to look for, to protect yourself.
The Pump And Dump Scam
This scam occurs when large shareholders in a penny stock “pump up”, or promote the company, making it appear more attractive to investors. Because the company is usually relatively unknown, it can be difficult for investors to verify the claims through proper research.
Once the increasingly popular stock hits a certain price, these shareholders suddenly sell, and the price tumbles, leaving regular investors left holding the bag.
The lesson: Don’t be fooled by slick marketing or hype, ensure that you’ve done the proper research prior to investing.
The Short And Distort Scam
With a short and distort scam, the scammer takes the opposite approach of a pump and dump. Rather than driving the price upwards, they take a short position on the penny stock, then use their influence to spread negative and misleading rumours about the company, driving the price downwards.
Once the price drops to a certain level, they close the short position and take their profit, leaving other investors with a worthless stock.
Helpful Tips For Buying Penny Stocks
If you do decide that you want to hold penny stocks as a small component of your portfolio, here are a few tips to help you make the best decision:
- Only spend money that you can afford to lose. Remember that when you invest in penny stocks, you are in essence gambling with your money. If losing 100% of your investment would have a major negative impact on your financial situation, or cause you significant anxiety, then it’s too much.
- Not all penny stocks are equal. Even within the world of penny stock investing, there are winners and losers. Do your research, and try to select companies with strong balance sheets. This usually means low to moderate levels of debt, and solid cash reserves.
- If your penny stock does well, be willing to take back your initial investment. If you are fortunate enough to choose a penny stock that shoots upward in value, consider selling off an amount equal to your initial investment. This way, you’ll only be playing with house money going forward.
- Research the company’s management. The success of a company is often determined by the quality of the people running the show. Get to know the track record of the executive team to get an understanding of their previous success.
- Diversify your holdings. In such a volatile sector, there are sure to be more losers than winners. To improve your chances, buy several penny stocks across a particular industry, whether that’s hi-tech, or mining, or something else altogether.
- Beware of penny stock scams. With fewer barriers to entry, penny stocks can be established and made to look attractive without an enormous amount of effort. Don’t be fooled by slick websites and splashy marketing campaigns. Dig deep to understand the fundamentals of any penny stock before you consider buying.
Where Can I Learn More About Individual Penny Stocks?
While I’m not in the business of recommending individual penny stocks, there are a number of sites dedicated to doing just that. If, after reading this article. you’re still interested in adding some penny stocks to your already diverse portfolio, here are a couple of places you can begin your search:
- Small Cap Power tout themselves as the investment industry’s “leading and most trusted source for small-cap stock coverage, research, and analysis.” Their site is packed with the latest news and analysis of small-cap companies. Check out this article on the best Canadian penny stocks to buy in 2018.
- All Penny Stocks is another website dedicated to providing information on penny stocks to investors of all experience levels. They have a lot of free content to peruse, including this regular feature, which lists the 50 top penny stocks (most actively traded) trading on the TSX.
Where Can I Buy Penny Stocks?
To buy penny stocks in Canada, you will need to deal with a broker, and the most cost efficient way to do that is through an online brokerage.
For 2018, my top choice for online brokerage is Questrade, due to their low overall fees and ETF accessibility. In fact, by using my exclusive link, you can earn $50 in free trades by signing up here.
For penny stock trading, Questrade offers two commission plans. For starters, they offer trades at .01/share, up to a maximum of $6.95. Alternatively, you can choose a fixed rate of $4.95 per trade.
With penny stocks, more often than not, you will want to choose the second option, as the number of shares you purchase will tend to be quite high, due to the low cost per share. This way, you will never spend more than $4.95 to buy penny stocks.
In addition to Questrade, there are many other online brokerages available that allow you to trade via OTC and/or pink slips. If you’re interested, feel free to check out my 2018 online brokerage review here.
Clearly, the world of penny stocks is a wild one. While not for the risk averse, or the buy-and-hold investor, penny stocks can offer substantial opportunities for growth inside a well diversified portfolio.
With the information I’ve provided here, my hope is that you feel well equipped to make the decision that is right for you.