Why People Invest in Penny Stock - dummies

Why People Invest in Penny Stock

By Peter Leeds

The number-one reason people get involved in penny stocks is to get rich quick. They have a few hundred dollars, which they need to turn into several million before the weekend so they can buy a yacht and pay their telephone bill.

The likelihood of getting rich quickly from penny stocks is slim. Those who focus on investing well, and perform their own due diligence, tend to do dramatically better.

Penny stocks appeal to the impatient

A significant proportion of investors who seek out low-priced shares through other channels, tend to embrace the volatility of the underlying shares. The potential to make significant moves very rapidly appeals to them, even as it exposes them to equivalent downside risks.

While impatience may be the reason why many investors seek out penny stocks, this character trait can cause investment problems. Impatient investors may sell shares at inopportune times, such as just before the stock begins reflecting stronger operational results. They may jump from investment to investment in a constant hunt for profits, which can lead to many poor trading choices.

To succeed with penny stocks, you need to substitute contemplation for impatience. Give the underlying company time to let its business plan play out. As long as it’s making progress, however slow, and the reasons you got involved with it in the first place still hold true, let the shares gradually reflect the improving operational results.

Keep in mind that the slower and more gradual the move up, the more sustainable the higher prices will be. Rapid and sudden price spikes typically don’t last.

The greatest gains in penny stocks come over years, not days. Shares that balloon from 5¢ to $5 only do so over the course of longer time frames, and one winner of this magnitude will trump all the 5 percent and 20 percent profits you may see from decades of trading. But only patient investors have the wherewithal to enjoy these kinds of benefits.

Newer investors gravitate to penny stocks

Typically, newer investors are interested in penny stocks because they believe there is less downside. They find smaller and newer companies less intimidating, and they expect such investments to be more attainable and appropriate for their minimal level of trading experience.

Although such reasoning isn’t without merit, it can be dangerous. There is just as much downside risk in a 1¢ stock as in a $99 stock. Also, finding high-quality penny stocks is much more difficult than uncovering good investments among larger shares, mainly because low-priced stocks have fewer companies of high caliber and a greater percentage of lackluster options.

Despite the aforementioned pitfalls, newer investors may find many benefits to starting off with low-priced shares:

  • Broader diversity of investments. Newer investors will learn much more from trading numerous types of investments, rather than just buying one or two. With penny stocks, you can spread a small investment among several stocks.

  • Greater volatility. Larger and ostensibly more boring investments will not teach their shareholders much. Penny stocks will display greater volatility and, as such, be more educational for the newer investor.

  • Price moves happen much more quickly. Whether your investment is going to go up or down, it will happen over a much shorter time period than with larger stocks. Newer investors tend to be attracted to these faster price moves.

  • Steeper learning curve. Newer investors have the most to learn. The combination of greater volatility in penny stocks, rapid price moves, bigger magnitudes of those moves, and the potential to own several different stocks at once, enables inexperienced traders to get up to speed very quickly.

For newer or less-experienced investors to quickly learn about trading, or to develop their own styles to afford them the greatest opportunity to profit, penny stocks may be the perfect outlet.

The term high-quality penny stock refers to specific criteria that add to the strength of the investment. Among other factors, these include a strong and respected management team, low debt loads, plenty of positive cash flow, positive earnings, growing market share, and low customer attrition rates.

Other criteria include having a solid position within an industry with high barriers to entry, strong alliances with top customers, improving financial ratios, and very effective branding and marketing.

Penny stocks appeal to smaller portfolios

Individuals with less money to invest may only be able to afford a few shares in a larger company. They also may not be too impressed by 5 or 10 percent gains, especially if that adds up to only $50 over the course of an entire year.

Given their situation, many investors with minimal portfolio values opt to not invest at all. Others gravitate to penny stocks.

Investors who believe in the power of penny stocks, yet who do not have a significant portfolio, understand that low-priced speculative shares may be the best way to increase their financial standing. Of course, not all traders who buy and sell penny stocks have a small portfolio, but a significant portion of traders with small portfolios do trade penny stocks.