Daily Gains Letter

Two Risk-Reducing Rules for Penny Stock Investors

By for Daily Gains Letter | Mar 26, 2013


Penny stocks certainly get a lot of attention from investors because of their ability to provide remarkable gains. While I’m not disagreeing with their claims, in the midst of all the glory about these types of stocks, investors sometimes forget the different risks associated with them.

If an investor only focuses on buying penny stocks then, to say the very least, their portfolio can be wiped out if they don’t properly assess their risks. Investors who are in the stock market for the long haul should only allocate a portion of their portfolio to penny stocks, because these stocks can create huge swings in an investor’s portfolio.

Note: by no means am I trying to say that you shouldn’t invest in penny stocks. Some of the major companies, at one point, were penny stocks. Consider Microsoft Corporation (NASDAQ/MSFT), for example. In early 1996, the stock traded for less than $5.00 a share. If penny stock investors bought Microsoft shares then and sold them in 2000 for $45.00, their gains would be phenomenal. This is just one example; there are many other companies that have produced even greater returns for investors.

With that said, when investing in penny stocks, investors must keep the following two rules in mind.


Rule #1: Don’t Get Lured into a Liquidity Trap

Contrary to big-cap companies on key stock indices like the Dow Jones Industrial Average, penny stocks usually have lower volume (the number of shares exchanging hands). As a result, investors find themselves in a trap. Sometimes, they may be willing to sell shares of a company after it has appreciated in price, but they may not be able to sell them without moving the price significantly lower.

Consider TigerLogic Corporation (NASDAQ/TIGR), for example. The stock trades just below $2.00, but its average 10-day volume is only about 3,500 shares a day. Therefore, if you buy large amounts of this company, you might just run into trouble when you decide to sell them. (Source: Yahoo! Finance, last accessed March 22, 2013.)

One step penny stock investors must take is to make sure that the company they are going to trade in has some volume. The reasoning behind this is that if things turn sour or even work out in your favor, you can get out quickly.


Rule #2: Look for a Company That Communicates with Its Shareholders

When an investor is trying to pick a penny stock to invest in, at the very core, they are trying to find companies that can grow significantly. The one main issue faced by investors is the lack of available information. For example, companies on key stock indices are followed by many analysts who try to provide guidance on where the stock might be headed; whereas, many penny stocks might receive minimal coverage by analysts. As a result, investors might make a decision about their investment based on very limited knowledge.

One way to become a better penny stock investor is to look for companies that are covered by analysts, have a proper reporting system, and communicate with their shareholders on a regular basis—through corporate presentations, investors meetings, and other communication tools.

The reason behind this rule is that if a company communicates with its shareholders, then they are updated on the company’s operations and what is to be expected in the future—the company’s shareholders can make better decisions this way.

Many investors believe penny stocks offer high reward, but they forget the risk. The two rules mentioned above are just two of many that penny stock investors should consider. As I have constantly said in these pages, investors must use risk management to reduce the volatility in their portfolio.

Just by looking at the amount of shares traded per day, and just by the amount of information available about the company, investors can certainly save their portfolio from drastic collapse.

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