According to the article Beware the Rise and Fall of Penny Stocks IPO it was noted that penny stocks lose an average of 21.7% three years after the initial public offering, compared with a gain of 44.4% for other stocks. Buying and holding penny stocks is a risky proposition for a few reasons.
For starters the true financial health of any given penny stock is in question. Along with this don’t be surprised by a wild variation in price at any given moment, as well as a small volume of trades at any time. If you look at the following 3 “Vs” you may realize that investing in penny stocks requires more effort than it may be worth unless you can find the right place for them in your investing strategy.
The information on penny stocks is scarce. The SEC doesn’t require these companies to file information with them and only the IRS audits them, and then only occasionally. Public information is usually only what is provided to media sources by the investor relations department of the company or from the occasional court filing or complaint to the better business bureau.
To get the type of analyst coverage the larger stocks receive there would just have to be more money involved. However, for the money to put up these types of research houses the investors could just buy some of these penny stocks. The return just isn’t there.
There is a term used when discussing volatility or risk called the beta coefficient. Beta is a measurement of how much a stock moves relative to another measurement. Usually the other measurement is an index, sector, or total market. When an index moves up the stocks generally move up too, however, how much that stock moves has a huge impact on its predictability. The complete basket of penny stocks or stocks within the sector is greatly affected by macro issues like taxes, credit markets, consumer confidence, and the like. These things are more easily predictable; however, with many penny stocks their beta is so great that it’s difficult to use macro issues to predict the direction of the stock movement.
Risk is the unpredictable part that is difficult to measure. When a stock moves wildly relative to the broader picture it is tied to, it is very difficult to come up with fundamentals that will give you accurate information on the direction of the movement. Even if you pick the long term direction correctly you may end up buying at an irregularly high swing, and in this case it may take years to recover.
The last part that makes buy and hold penny stocks difficult is the daily volume. Often these stocks are traded so thinly that in order to accumulate a significant amount of stock for long term investing you have to change your own price or there simply isn’t a seller available. This is very frustrating for those of us who are used to investing on the New York Stock Exchange where instant transactions are guaranteed.
The other danger is selling into low volume. The reason you invest is to have money for the future. The key part is having that money. If you are unable to sell the penny stocks when you need the cash the value of the investment for your own personal life is significantly reduced.
So Why Bother with Penny Stocks?
A different style of investing is required when you have thin volume, high volatility, and no company information. It’s called day trading. The advantage here is you’re eliminating the risk of time while using the volatility to your advantage. You can control the downside of a trade with stop losses; this chops the loss potential. The upside of a trade is large because of the very large beta. You don’t need very many shares so the volume doesn’t matter. You will just be trading many times in a row.
Day trading isn’t for everyone, but it can provide a non correlated return on your investments from regular Wall Street investing. Non-correlated returns reduce risk. So in essence you’ll be using riskier stocks to reduce your overall risk. Pretty cool actually._____________________________________