Risk vs. Reward: Adding Penny Stocks to Your Portfolio

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Penny stocks are the ultimate high risk, high reward stocks that aggressive investors target to diversify their respective portfolios. Investing in penny stocks requires a lot of care, caution, and research, as there is a strong potential for huge losses. Considering their volatility, few full-service brokerages offer them to investors, with many of the shares offered by companies struggling financially or having a small following. 

There are various strategies to make money from investing in penny stocks, though they require a lot of diligence and quick thinking to succeed. What are the potential risks and rewards of adding penny stocks to your investment portfolio? 

How Do Penny Stocks Work?

Also known as microcap stocks, penny stocks are typically traded for minimal values, typically for less than $5 a share. The Securities and Exchange Commission, by contrast, defines penny stocks as stocks with a market capitalization of up to $250 million. Most penny stocks aren’t listed on major stock exchanges. Some are listed by Nasdaq and the New York Stock Exchange (NYSE). However, most penny stocks are traded over-the-counter transactions or via the electronic Over The Counter Bulletin Board (OTCBB). 

Penny Stocks Require Caution and Good Information When Investing 

Sticking with the major exchanges like Nasdaq and the NYSE is a wise approach to penny stock investment. Several penny stocks are listed on both stock exchanges between $1 and $5. By trusting in the major stock exchanges, investors are less likely to be tricked into fraudulent deals. Additionally, the liquidity offered on the major stock exchanges is better than what’s offered over the counter, making them more attractive. 

Reliable information is hard to find with many penny stocks. However, investors can look at companies that recently traded on major exchanges that fell below the $5 mark. Professional traders can use this information to make more educated decisions when investing in penny stock companies. 

Additionally, you need to be conservative with fees when conducting penny stock investment. Investors should seek platforms without huge fees and commissions, ensuring bigger returns from these inexpensive stocks. Investors also need to determine how much money they’re willing to lose given their high volatility levels, setting aside an amount for the stocks rather than investing high amounts of their savings. 

Why are Penny Stocks So Risky?

The high price volatility that accompanies penny stocks is one reason why investors are wary of adding penny stocks to their portfolios. Given that penny stocks have low prices, any small shifts in the price will represent large percentage gains, while small absolute losses can represent significant percentage losses. Huge shifts in price happen one way or another, making penny stocks more of a short-term investment. 

Because limited information about penny stock companies is available, many investors either buy blind or have to invest more time than normal to research them. There is a limited track record accompanying many of the available penny stocks, featuring lower reporting requirements and making it harder to research them before investing. 

Additionally, penny stocks carry many risks due to their low trading volume. When you buy stocks on a major stock exchange like the NYSE or Nasdaq, there is an extensive market saturated with buyers looking to purchase varying amounts of shares. If a buyer doesn’t want to buy all of an investor’s shares, brokerages will take their stocks as they are confident they will identify buyers going forward. By contrast, penny stocks have few buyers and market makers, regardless of whether they are listed on a major stock exchange or via OTC. Even if investors realize a profit with their penny stocks, they aren’t guaranteed to realize their gains.

Fraud is Rife With Penny Stocks 

One of the biggest concerns with penny stocks is the number of scams and fraudulent activity to lure investors and steal money from them. 

Many penny stock scammers lure investors with limited experience, including through pump-and-dump schemes, the most common type of scam. Scammers stir up interest in companies with limited (or non-existent) track records, convincing inexperienced investors to purchase the stocks. When the stock reaches highly inflated levels, the scammers sell or dump stocks for huge profits, leaving investors in a highly uncomfortable situation. Free penny stock newsletters typically distribute these pump-and-dump schemes to catch unaware investors. 

There are also reverse merger deception schemes where private companies merge with public companies to become publicly traded without dealing with the expenses and stresses associated with going through traditional listing methods. Private companies can inflate their stock prices and lie about their earnings to catch investors. Some reverse mergers are legitimate. But, investors can catch deception schemes by reviewing business histories and finding out any shady activity within the merger. 

Other types of scams to look out for when investing in penny stocks include, but aren’t limited to: 

  • Guru scams
  • Mining scams 
  • Offshore Rackets

How Do You Reap Rewards with Penny Stocks?

Devising a plausible risk-reward assessment for your penny stocks is paramount to seeing even a modicum of success with your investment. You should first consider limiting your holding and diversifying your investment when engaging in penny stocks. By capping losses and limiting stock holdings to no more than 2% of your portfolio, investors will increase their return potential. Plus, it’s advised that investors diversify their penny stock portfolios, which shouldn’t move past the 10% mark of the overall portfolio. 

Penny stocks are rarely fruitful long-term as the sector is based on short-term success. When garnering sizable short-term gains, it’s better to cash in now rather than wait for bigger profit margins that never materialize. Penny stock investors should identify high-quality stocks, including initiatives set up by experienced managers who successfully exited a previous company. Investors should also consider stocks with encouraging outcomes in industries like natural resources and biotechnology. 

Alternatively, there are penny stock companies dubbed as fallen angels, companies that were once highly promising and profitable who faced debilitating setbacks but have strong comeback potential. Many of these fallen angels can be found in the technology industry. 

Few companies elevate themselves from being penny stocks to power stocks. But, if investors can find those companies, they can net heavy returns as such companies that make the jump pay huge sums of money.

In 2022,there are many penny stocks worth investing in, but strong risk management skills and awareness of the more suspect side of the industry are required to see financial rewards with a hugely volatile asset.