Why You Should Stay Away From Penny Stocks
HDFC, Tester
Penny stocks! You have probably heard of these at least once. If you’re new to the stock market and intend to stick around for long, it would do you good to know about penny stocks and why you should stay away from them. First, let’s understand what penny stocks are.
What are penny stocks?
These are the small capital company stocks that have a very low price attached to them. This makes investors believe that they are buying some real cheap equities. Many investors, especially the less experienced ones, find the penny stocks attractive because of their low price. Several novice stock market investors tend to prefer buying 10,000 shares of a penny stock (priced at 1 rupee) instead of a stable company stock that is priced at INR 1000 or more.
The thought process for them goes like this: With an investment amount of INR 10,000, one can purchase as many as 10,000 shares of the 1 rupee penny stock. On the other hand, one can purchase only 10 shares of the stable company stock with a market price of INR 1000. Such beginners to the stock markets fail to understand the difference between price and value. Just because you can buy more shares of a company doesn’t mean that you will earn more profits.
Key features
These characteristic make penny stocks the riskiest segment of the markets.
- Trading at a low price
- Low liquidity since shares available for trading would be limited in the market
- Belong to small capital companies usually below 100 crores
- Unpredictable and uncertain
Reasons why you should refrain from investing in penny stocks.
1. High Risk: Higher the Risk, Higher the Reward. This is a common notion passed around in the stock market. In the case of the risky penny stocks, the probability of getting the rewards will be too less. Maybe 1 out of 10 penny stocks could give you rewards.
There have been cases where people have waited for more price rise in penny stocks, and then got stuck because the price started falling continuously after reaching a certain high level. This is because it is not possible for any investor to judge the appropriate levels of exit from a penny stock, even when it turns profitable. Plus, there is no guarantee that a penny stock would remain profitable in the long run. There have been numerous examples of penny stocks that were profitable for investors at one point in time, but are now lurking around price levels below their purchase price. Before you even know it, many of the penny stock companies may turn bankrupt.
2. Manipulative Nature: Because of the low market capitalization of penny stock companies, it is extremely easy for any trader to manipulate the price of penny stocks. Someone can simply buy a huge quantity of these shares with an investment amount of 1-2 crores and cause the stock price to rise. This tends to create an illusion of heavy demand and amateur investors start pumping money in without knowing the facts. This gives the initial manipulator an opportunity to exit the stock with heavy profits, leaving other investors stuck with the penny stock. Some of these instances have even been reported by SEBI.
3. Low Liquidity: In case of penny stocks, the quantity of shares available may appear to be quite high. In reality, the quantity is limited. You can also expect considerable price movements in terms of percentage. For example, a stock priced at 50 paise can easily by 5-10 paise in a day making it a 10-20% rally. Due to possibilities of such volatile price movement in any kind of stocks, exchanges generally limit how much a stock can rise or fall in a single day. The same holds true for penny stocks, on which there is a 5-10% limit beyond which price cannot rise or fall in a day for a particular stock.
You are likely to face difficulty in buying such penny stocks. Due to non-availability of shares in the market, there may be no sellers at times when there is a huge demand. A similar difficulty could arise when you try to sell the stock. There may be no buyers or the share price has reached its lower limit for the day. In penny stocks that deliver bad results or have some bad news floating around, it is normal for investors to wait for several days or even weeks before they could sell off the stock. But by then the price falls so much that it results in a huge loss.
4. Lack of Consistency in Performance: Many investors go for penny stock companies, hoping that they would turnaround their business sooner or later, and become bluechip of tomorrow. However, the turnaround for such companies is very difficult. Good performance in 2-3 quarterly results doesn’t make a turnaround case. For a real turnaround scenario, a small cap company has to have a series of good annual results, after which the investors can start benefiting from a long-term perspective. Such turnarounds are very rare. Most of the times, such companies fade away after giving a couple of good quarterly results, leaving investors with nothing but hope and a junk stock!
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