Call the companyOne of the most important things you can do when considering whether to invest in a company is to pick up the phone and call it. Never invest in any penny stock until you have spoken to, and asked questions of, the management or at least its investor relations contact.
You can discover more in a twenty-minute call than you might find from hours of research. In fact, some of the information you glean from that call isn't available through more conventional means.
Average upSavvy investors average up, meaning that they buy more shares when their investment increases in price. After their initial purchase, the rising share price vindicates their beliefs and expectations about the company and the prospects for the shares, and they increase their position in the stock as it rises. Their average price per share will increase because they bought more at this higher price, but they don't mind paying for a stock that's moving in the right direction.
Less experienced investors tend to average down, which is the process of buying more shares of an investment that is falling in value. In other words, when they see the value of shares they have already bought sinking, they purchase more to lower their average price per share.
In theory, averaging down sounds like a good strategy. If you have 500 shares of a stock whose value has dropped by 40 percent, buying 500 more shares means your total investment is now down only 20 percent.
The problem with this strategy is that you may be doubling down on your original mistake. After all, you were wrong about the shares in the first place, so why should you invest even more money in the stock?
Don't confuse market risk with company riskWhen you invest in any stock, you want to be sure that you understand the difference between the two types of risks involved. These are as follows:
- Company risk. This type of risk involves anything related to the specific stock of the corporation you're investing in.
- Market risk. Market risk is based on the potential downside for any shares when the overall stock market declines. If all investments suddenly crash in value, even excellent up-and-coming companies will drop. This risk isn't based on the operations of the underlying company, and frankly there is nothing they could have done to curtail the weakness in their shares that resulted from market risk.
Watch the competitors and the industry, because if a specific stock is trading in line with the rest of the stocks in that industry, you can safely assume that any downside move is based on market risk. On the other hand, whenever a company is trading very differently than the rest of the group, you can probably attribute it to company risk.
Try the product, use the serviceUsing a company's product or service can sometimes be more effective due diligence than analyzing the financial results. Especially with penny stocks, where the adoption and early usage of the wares can make or break the company, you want to know exactly what they're selling.
Never invest in a company without trying its products or services, assuming that doing so is a realistic option. Giving the products a test drive is often a low-cost form of due diligence that could provide greater clarity than the majority of Wall Street analysts derive from the lifeless numbers on the company's financial reports.
Compare the waresTo go a step beyond trying a penny stock's products or services, take a look at what the competition is offering. When considered in a vacuum, a company may have a great technology or franchise restaurant or motorcycle helmet, but as soon as you look at the alternatives that are available from other sources, you may change your mind (or reaffirm your original assessment).
For example, to truly do full due diligence on a company's new software program, you need to assess it in relation to the alternatives. You may find strengths and weaknesses that you hadn't noticed before.
An added bonus to assessing the merits of the competition is that you may discover superior products and services. Through the process you may end up with a much better potential investment, which you may not have been aware of when you started looking into the original company.
Paper tradePaper trading is a form of virtual investing that gives you the opportunity to learn the ropes: You get to see how your penny stock trades would have done without risking any capital.
The benefits of paper trading are many, and the downsides are few. The technique gives you a chance to improve your skills without risking a single penny and to refine your strategy by investing an imaginary portfolio that is many times greater than the actual amount of money available to you.
Newer investors absolutely should start by paper trading. Even more experienced traders can benefit as well. This approach helps lead the way to finding those penny stocks that will produce significant returns, while insulating against mistakes and downside risk.
Know the corporate life cycleAll companies go through what's called the corporate life cycle — they transition from startup to growth and then into maturity and, eventually, decline.
By knowing where a company is at in its corporate life cycle you can really get a leg up on your investment decisions. Specifically, being aware of the phase a company finds itself in will shed light on what to expect from the stock and where the company's corporate priorities lie.
As the company moves through the phases of the corporate life cycle, it has very different strategies and goals, which will be reflected in how you should value and treat its shares.
- Start-up phase
- Growth phase
- Maturity phase
- Decline phase
Awareness of the corporate life cycle, especially with knowledge of where on that life cycle your stock sits, will go a long way to helping you make the right investment decisions.
What's really driving the share price?Sometimes the shares of a stock change in price for reasons you're not aware of or haven't even considered. Taking the time to figure out exactly what is driving the shares, as opposed to what the majority of investors are assuming is moving them, gives you a major trading advantage.
Just like a company can have a competitive advantage, knowing why the shares of penny stocks are moving can be your investing competitive advantage.
Watch the short interestThe short interest demonstrates what percentage of shares in a company is held by short sellers, who profit when the stock decreases in value.
Short sellers expect the price of shares to decrease. They profit when this occurs by selling the stock first and then hoping to buy those shares back later at a lower value.
Large short interests may indicate that a significant portion of investors have reason to expect that the shares will decrease in price. For example, if the short interest is over 20 percent, a potentially negative event for the shares is widely expected, or perhaps many traders are anticipating the company to have troubles.
You can easily check the short interest of any stock through any online financial portal like Yahoo! Finance. Short interests will typically be below 10 percent, and any values higher than that may indicate a cause for concern among investors.
Don't diversify, pinpoint invest insteadFinancial advisors like to tout the merits of diversification. The idea is to spread your investments out among several stocks as a means of minimizing the overall impact of a dropping price on your portfolio. In many cases, diversification is a great strategy; if you divided your money between eight stocks and one slid lower, it would only have a negative impact on one-eighth of your portfolio. Compare that to putting 100 percent of your money into one stock, and that investment dropping. Your resulting downside would be significant compared to a diversified portfolio.
Investors can diversify in many ways. Besides buying a greater number of stocks, they often choose shares from different industry groups, various ranges of price per share or company size, or even spreading their investments between companies from different countries. Many people also like to own various investment types, such as some index funds, some bonds, some individual stocks, and some precious metals.
Diversification also increases your odds of getting an investment that performs poorly. When you buy a dozen eggs, there is a chance that one may be cracked in the carton. If you're worried about getting a cracked egg, you could buy five dozen. That strategy increases your odds of having a carton without a broken egg, but it also increases the probability (by a factor of five times) that you'll get a cracked one.
Instead of diversifying, embrace pinpoint investing. This strategy involves buying fewer stocks, with a greater percentage of your total portfolio invested in each.
Depending on your own investment portfolio, whether it's worth $1,000, $50,000, or otherwise, you may also perform better with pinpoint investing than you would with diversification.