Stock Market Investment: Should you invest in penny stocks?

Let us understand the nuances related to penny stocks, how it is beneficial, the risks associated and factors to be considered when selecting penny stocks as a part of the portfolio.

stock market, stock market investment, penny stocks
Though investing in these shares are quite efficient, there are other options which are available to the investors to achieve their desired financial goals.

To generate wealth, it is essential to do proper asset allocation. In this context, investors generally look at equity shares as part of their portfolio, focusing on large and mid-cap shares which are well established, have a good track record of generating profit, etc. Though investing in these shares are quite efficient, there are other options which are available to the investors to achieve their desired financial goals.

One such option is investing in penny stocks. Let us understand the nuances related to penny stocks, how it is beneficial, the risks associated and factors to be considered when selecting penny stocks as a part of the portfolio.

What are penny stocks?
These are shares of low value, usually associated with small companies with lower market capitalisation. Simply put, penny stocks are shares that attract minimal investment from investors. In India, a penny stock is a share whose market value is `10 or less than that. In general, penny stocks are quoted with two prices—the bid price and the ask price. Dealers offer bid prices when they are willing to buy securities from you, while they declare ask prices when they are willing to sell them. The difference between the bid and ask prices is called the spread, which varies for different penny stocks. Spreads are used to indicate how expensive or cheap a penny stock is.

Is it beneficial?
The first benefit of penny stocks is that they are an excellent investment option because penny stocks offer greater room for experimentation and also provide new investors with the opportunity to learn how to trade. Second, the affordability of penny stocks can be attractive. This affordability can be mainly attributed to the market price of the shares and since the share prices are very low so is the risk associated with them. Thirdly, such stocks are primarily speculative in nature, professional or technical analysis is not required to trade with them. Finally, penny stocks offer high returns as they are usually issued by small or micro-cap companies with growth potential. So, if proper homework is done by the investor, investing in penny stocks for the long term might generate higher revenue.

What are the risks associated?
The trading in penny stocks is infrequent mainly because of the wide bid-ask spread and low market capitalization, making it vulnerable to price manipulation and high volatility. The first risk associated with the penny stocks is that they are susceptible to price manipulation. It is possible to change the movement of the stock by buying thousands of shares and causing a spike without leaving any clues for the average investor as to whether the spike is genuine or manipulated. Hence, investors should be aware of the market sentiment and other related aspects of penny stock investing. Secondly, the investors often do not have necessary information related to the company which issues penny stocks.

Usually, penny stocks are issued by small companies. It is difficult for investors to assess these companies’ financial stability and growth potential. So, lack of such vital information might mislead the investors and may cause a huge hole in their pocket. Further, the penny stocks are not so liquid so finding prospective buyers and sellers is sometimes difficult. Due to the low liquidity, investors may not be able to do price discovery. As a result of these risks, stock exchanges have placed these types of stocks in a separate category called trade-to-trade baskets or T-category shares wherein intraday trading of shares is not allowed in this category. Gross settlement is compulsory, meaning you must deliver the shares the same day if you sell them or take delivery if you buy them.

It is not necessary for all penny stocks to fail. Given the above mentioned benefits and risks, investors could consider including penny stocks in their portfolio according to their risk appetite and financial goals. But before investing in penny stocks, investors should equip themselves with information related to the financial stability, past performance, and other business prospects of the company in which they propose to invest.

The writer is a professor of finance & accounting at IIM Tiruchirappalli. With inputs from A. Paul Williams, research staff at IIM Tiruchirappalli

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