If you don’t have much capital in hand for stock market investing, penny stocks may prove to be quite the match for you. This is primarily because they are less expensive than other listed stocks, as they are newer to the market. Penny stocks in India proved to be the biggest beneficiaries in 2021. As many as 30 penny stocks delivered 1000% in the previous year, and 90 of them went over 500%.
You might have heard that penny stocks in India are mostly stocks of unknown companies with doubtful business models. Though this does happen many times, it’s not always true. Let’s learn more about investing in penny stocks and whether or not you should add them to your stock market portfolio.
What are Penny Stocks?
Penny stocks do not simply mean those stocks that cost pennies. These are shares of companies with a low market capitalisation, i.e., small-cap companies. Penny stocks in India, refer to those stocks that trade for Rs 10 or less. However, you might find that a few analysts include stocks quoting less than Rs 20. This is because there is no theoretical definition of penny stocks.
In the US, stocks that trade for $5 or less are defined as penny stocks.
Though these stocks are riskier, they have the potential to earn great returns on a small investment. For example, Company A is trading at the rate of Rs 5/share in the stock market, and you own 1000 shares of the company. Your invested capital would then be Rs 5,000. If the stock price rises even by Rs 1, you will earn a return of Rs 1,000. This gives you a 20% return in a single day.
Investors require huge capital to buy such a large quantity of shares. So this is usually not possible in stocks of large-cap companies.
Risks of Investing in Penny Stocks
1. Low liquidity:
Since the market capitalisation of penny stock companies is low, these securities trade less frequently in the stock market. Due to low trading volumes, it might prove to be quite a challenge to find potential buyers or sellers. As a result, penny stocks have high basis risk, i.e., the bid-ask spread is very large. Bid-ask spread is the difference between the buy price and the sell price. Thus, a high or a wide bid-ask spread means that there is a low volume of demand, and there might be wider discrepancies in the stock prices.
2. Unproven and small companies:
As discussed above, penny stock companies have a small market capitalisation, i.e., companies with a market capitalisation below Rs 5,000 crores. These companies are yet to show their true earning potential. And they are not very established in the market.
3. Scams and traps:
Many times, brokers partake in the circular trading of penny stocks to earn huge profits in stock markets. Circular trading is when a few brokers enter into an agreement with the company promoters to drive up its stock prices by creating a false demand. They build hype about the penny stock and pump up its share price, which misleads investors into thinking of it as a sign of the company’s success.
After the stock prices increase, the traders (scammers) sell/dump their shares to earn a huge profit and stop further promoting the stock. This results in a decline in the prices of the penny stock, and late-arriving investors, which are usually retail investors who believe the hype, incur huge losses.
4. Limited information available
Information on the corporate performance of companies with pe4nny stocks may not be easily available, and what information is available, is usually not from a credible source.
To invest or not to invest?
If you are still interested in investing in penny stocks after reading about all the above-mentioned risks of penny stocks in India, then you should keep the following tips in mind.
Penny stocks have features like low promoter holding, huge debts, accumulated losses and poor dividend track record. It is advisable for investors to understand intricately the limitations and principles of penny stocks, and make an informed decision about investing in them
A rise in stock prices is usually backed by fundamental analysis factors like good management, business expansion and financial position. However, this is not the case in penny stocks. So, investors should be careful and not be a victim of buying low-valued shares.
Your stock market portfolio should not comprise more than a 4% allocation in penny stocks. We all know the saying, “Never put all your eggs in one basket”. History shows that in the long run, high-quality stocks are the ones that create wealth. Not all companies turn out to be the next Google or Amazon. In the current market scenario, where there is a bullish view on stocks, all stocks are bound to go up. However, once this bull run ends, penny stock investors might face huge grief.
Don’t be too greedy with your penny stock investments. Investors should be realistic with their return expectations. As penny stocks operate in a highly volatile and risky environment, many investors suffer big losses in an attempt to earn huge returns. You must determine the maximum capital you’re willing to lose and limit yourself to that amount. In that case, if your investment goes under, you won’t be in a huge financial crisis.
Wrapping Up
All equity instruments carry some degree of risk, and similar is the case with penny stocks. That being said, penny stocks do carry a higher level of risk, and have a low trading volume, with dynamic price movements. However, if you do proper company analysis and stock research, then you can take care of such risks.
One way to choose a good penny stock that will earn huge returns is by conducting extensive fundamental and technical analysis and doing your own due diligence on the company in question.