The Risks and Rewards of Investing in Penny Stocks
Penny stocks are known for their high rewards, affordable prices, and appeal to those willing to take risks. However, the risks associated with penny stocks include high volatility and low liquidity. This makes them prone to market manipulation, which can result in financial losses for investors.
In this blog, we will give you an overview of the risks and rewards associated with penny stocks, along with tips to balance them effectively.
What are Penny Stocks?
Penny stocks are publicly traded companies with market prices below ₹10. The market capitalization of these stocks or companies is significantly lower than that of large-cap or mid-cap companies. Investment in penny stocks carries much higher risk because of low liquidity and high volatility.
In the past, there have been various instances when a penny stock got delisted from the stock exchange, resulting in losses to the investors. On the other hand, there have been some penny stocks in the past that have generated multi-bagger returns for their investors. Investors generally get attracted to penny stocks because of their high growth potential and low entry cost.
The Rewards of Investing in Penny Stocks
There can be significant rewards of investing in penny stocks for investors; a few of such potential rewards are mentioned below:
- Growth Potential: Usually, penny stocks are stocks issued by emerging companies that have significant growth potential in the long run. If the company performs well, its stock prices can give multi-fold returns over the long run.
- Low Capital: Because of their low prices, investors can buy these shares in huge quantities, making them popular among investors with limited capital.
- Multibagger: Various penny stocks have the potential to generate exponential returns because of the business or sector in which they are operating. If proper research is conducted, you can identify the potential multi-baggers that can give 2X, 5X, or 10X returns in a short span of time.
- Early Investment: Penny stocks can provide an early opportunity to invest in promising companies or startups before they achieve widespread recognition among retail investors.
- Immediate Gains: Sometimes, penny stocks deliver instant gains due to market speculations or any other positive news. Hence, it creates trading opportunities for active traders to profit from short-term price fluctuations.
Read Also: Penny Stocks – Definition, Features & Top List
The Risks of Investing in Penny Stocks
Investing in penny stocks carries higher risk because of their inherent nature and the risk associated with small companies. Here are some of the major risks of investing in penny stocks:
- Limited Information: Penny stock companies have limited publicly available information. This lack of transparency makes it difficult for an investor to understand the fundamentals and growth potential of the company.
- Volatility: Penny stocks can experience high fluctuations in prices within a short period. While volatility can lead to quick returns, it can significantly increase the chances of substantial losses.
- Liquidity: These stocks generally have low trading volume, which makes it difficult for buyers and sellers to execute trades. You might have to bear losses if you need to sell them quickly at unfavorable prices.
- Delisting: The chances of getting delisted from the stock exchange are higher in penny stocks as they may not meet the listing requirements. It can make it even harder to sell your shares and may result in significant losses.
- Manipulation and Fraud: Penny stocks have a higher chance of being manipulated by speculators, and investors can be victims of pump-and-dump schemes. There have been many instances of manipulation and fraud in the past associated with penny stocks.
Balancing the Risks and Rewards
To balance the risk and reward ratio of penny stock, one can follow the below-mentioned tips:
- Limited Risk: You should only invest an amount in penny stocks, which you could afford to lose because penny stocks carry high risks. Hence, only a small portion of the total investable capital should be invested in penny stocks.
- Deep Analysis: Investors should not only focus on stock price but should also evaluate the company on various parameters such as their financial health, business model, management etc.
- Rumors: Do not invest in penny stocks based on any tips or rumors, as it can lead to losses.
- Realistic Expectation: No doubt penny stocks can offer high returns, but it does not mean that one should invest in penny stocks with an aim to earn 2X, 3X or 5X returns quickly. An investor must set a realistic return expectation from penny stocks.
- Periodic Review: A periodic review must be done to keep your portfolio aligned with your investment goal. Stay updated about news, industry trends, etc., as these factors can affect stock prices.
- Stop-Loss: A proper stop-loss must be placed to limit any potential losses in case of a sudden fall in stock prices.
- Liquidity: It is advisable to invest only in penny stocks that have high liquidity or higher trading volumes.
- Fundamentally Strong Stocks: One is required to invest only in fundamentally strong stocks that offer high growth potential, as these companies are less risky.
Read Also: 10 Fastest Growing Penny Stocks in India
Conclusion
On a concluding note, investing in penny stocks is exciting and rewarding as it offers high returns. However, various risks such as volatility, liquidity issues and lack of transparency make them unsuitable for a lot of investors. To successfully pick the best penny stocks, you must balance the risks and rewards appropriately. Investing in penny stocks requires proper research and patience. Before making any investment decision, you should consult your investment advisor.
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Frequently Asked Questions (FAQs)
How do you invest in penny stocks?
To invest in penny stock, you should have a demat and trading account. If you want to invest in penny stocks, you can open a free demat account with Pocketful, which also offers free brokerage on delivery trades.
Are penny stocks suitable for beginners?
Penny stocks carry high risks and require proper research before investing, which makes them suitable for experienced investors who have a high risk tolerance.
How can I manage the risks and rewards associated with penny stocks?
To balance the risks and rewards of penny stocks, one needs to allocate only 5% of their portfolio to penny stocks and conduct proper research before making any investment decision.
How can I avoid scams such as pump-and-dump schemes in penny stocks?
To avoid frauds like pump-and-dump schemes, one must analyze the company’s financial reports, avoid investing in stocks aggressively marketed by promoters, and track the trading volume on a regular basis.
How to find penny stocks?
To find a penny stock, you can use a stock screener to filter the stocks based on the current market price criteria. After identifying the stocks, go through their financial reports, business plans, etc.
Disclaimer – The securities, funds, and strategies mentioned in this blog are purely for informational purposes and are not recommendations.
